It’s Time for Some New Fixed Income Flavor in Your Portfolio

Equity investors can put their money to work across nine style boxes (think of the large-mid-small/growth-core-value matrix). That’s some diversification potential. Why is it then that some investors only have one flavor of fixed income in their portfolios?

Why would investors demand nine styles of equity, but seldom have more than one fixed income allocation – usually a core or core-plus strategy benchmarked to something like the Barclays Aggregate Index? Up to now, it can be partially explained by lack of demand. A 30-year bull market in bonds has meant that a core or core-plus fixed income allocation has tended to do well over that time. But now things are different. As we enter a period of rising rates and higher volatility, you need to ask yourself if your traditional core fixed income portfolio can still generate attractive risk-adjusted performance.

I’d suggest that what might fill the void, or replace the current paradigm in fixed income, are opportunistic fixed income portfolios. These are fixed income portfolios that aren’t managed against any particular benchmark. They’re typically free to adjust their duration as needed, and they usually have the flexibility to go after the portfolio manager’s best ideas. Investors will need additional sources of alpha, apart from duration, and this is what opportunistic fixed income can offer.

One of the big issues that’s emerged in fixed income is an increasing correlation among core and core-plus managers. In fact, over the past five years, there’s been a remarkable lack of diversification in fixed income managers – managers have all tended to look the same, or at least very similar. Think about it like this – most big core and core-plus managers are running their duration and credit-quality positions very close to the index (Barclays Aggregate, or similar). That’s two sources of potential alpha that are now highly correlated among the majority of fixed income managers. As interest rates start rising, it’s now probably the time to get some diversification in your fixed income allocation. Yields have fallen and credit spreads have tightened across the market. Going forward, we expect this to change. Rising rates and higher volatility will likely start to accentuate the differences in managers’ strategies and lead to lower correlations among fixed income managers over time.

One answer that we’ve seen in the markets recently has been a move towards duration-specific strategies, for example short-duration fixed income. This goes part of the way to solving the issue, but not the entire way. First of all, short-duration fixed income often can’t offer the higher yields that many investors need. Second, adding or switching to duration-specific strategy may be a short-term solution to a longer-term issue. When the time comes to add duration back to the overall portfolio, investors won’t be able to move as quickly (have to fire the short-duration manager, then hire an intermediate-duration one) as an unconstrained manager can. An unconstrained or opportunistic manager can also move to capture an ever-changing opportunity set, which a short-duration-only manager couldn’t do, and could do so more quickly than the investor alone. Besides, to truly add diversification to your fixed income allocation, you need to grab more sources of alpha than just duration and yield.

We haven’t seen the “great rotation” out of fixed income and into equities because investors need to be allocated to fixed income to maintain a diversified portfolio – but don’t let the diversification stop there. Diversify further by shifting fixed income holdings out of core and core-plus strategies and into opportunistic and unconstrained strategies that can help investors achieve their investment goals in this new era of rising rates and increased volatility.

 

The information in this article has been derived from sources believed to be accurate.  Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity.

The information in this article contains general information only on investment matters and should not be considered as a comprehensive statement on any matter and should not be relied upon as such. The general information it contains does not take account of any investor’s investment objectives, particular needs or financial situation, nor should it be relied upon in any way as a forecast or guarantee of future events regarding a particular investment or the markets in general. All expressions of opinion and predictions in this document are subject to change without notice.

Subject to any contrary provisions of applicable law, no company in the Principal Financial Group nor any of their employees or directors gives any warranty of reliability or accuracy nor accepts any responsibility arising in any other way (including by reason of negligence) for errors or omissions in this article. Any reference to a specific investment or security does not constitute a recommendation to buy, sell, or hold such investment or security.

Links contained in some blog posts may take you to third-party sites and Principal Global Investors makes no guarantees to the accuracy of the information provided.