With sovereign bond yields and credit spreads trading at near historic lows, and an ambiguous macroeconomic environment, traditional bond portfolios are no longer looking that compelling. Such portfolios are typically managed relative to an aggregate index, with limited flexibility to expand their opportunity sets and tool boxes and at this point, following a 30 year bull market for the bond market, prospective returns from traditional bond portfolios do not look that attractive.
When faced with meagre prospective returns and a potentially riskier market environment, investors generally head for the exits and rotate their portfolios to what they perceive to be more attractive alternatives. At times like these, it is important to remember one thing: stay invested. As part of any diversified portfolio, fixed income assets play a vital role in portfolio construction. Simply ignoring fixed income assets from the asset allocation decision defeats the purpose of constructing a diversified, multi-asset portfolio.
Given the risks posed by the macro environment and monetary policy to fixed income assets, we think it has become increasingly important for investors to consider unconstrained fixed income strategies that can diversify risk as well as add new potential sources of return to their portfolios.
As the name suggests, unconstrained strategies are not limited by a traditional benchmarked approach and have the flexibility to invest in a wider opportunity set. In brief, such strategies take a flexible approach in assessing and taking investment opportunities, while actively managing portfolio risk. This often means the portfolio is managed with an absolute (positive) return focus regardless of the market environment. These strategies are generally "go anywhere" strategies, with the traditional benchmark orientated constraints removed, thus allowing a greater ability to pursue opportunities relating to interest rates and yield curves, currencies, credit and volatility.
The primary risk management tool available to portfolio managers of these strategies is duration management. Duration, a measure of interest rate risk, is an important consideration for any fixed income manager faced with the prospect of rising rates. Rising rates (yields) equate to lower bond prices. By lowering the duration of their portfolios, managers can reduce the pure interest rate risk they are exposed to. The ability to run a negative duration position is also possible within these strategies, which would allow portfolios to produce positive returns when interest rates rise.
What about corporate credit?
Outside of vanilla sovereign bond exposure, investors can also gain exposure to investment grade corporate credit. Some corporates offer floating rate bonds which are attractive instruments in a rising rate environment, as these securities have coupons that increase when interest rates rise.
Investors demand a higher yield for lending to corporates, as a form of compensating them for the possibility of default. All else being equal, the higher the perceived risk of the borrower, the higher the yield investors demand. The additional yield on both investment grade and high yield debt over government bonds, called credit spread, is trading near historically low levels, implying that investors are not overly concerned about default risk. It also means that investors are being poorly rewarded for the potential risk which they are taking. This is not inconsistent with other asset classes, as investor demand for income yields have compressed credit spreads and other risk premia.
Looking outside of an investor's home market, international exposure to both developed and emerging markets offers investors additional sources of return and diversification benefits. Foreign currency exposure also forms part of the decision to invest internationally. Currency exposures are often hedged in fixed income portfolios as an incorrect view on the direction of a volatile exchange rate can erode the steady return earned on the foreign assets.
Unconventional fixed income sub-sectors
Looking away from the more conventional instruments like government and corporate bonds, various securitised products exist that offer attractive risk/return characteristics. While these may sound risky to some, for those willing to do the necessary work, these instruments can be an excellent addition to a fixed income portfolio but clearly are reliant on the strength of the collateral - as investors discovered during the credit crisis. There are however some other strategies which we have seen being promoted as fixed income replacements (i.e. catastrophe bonds, royalties) which we think carry very different risk to traditional fixed income. Investors should be fully aware of the risks to which these strategies expose them as often the return stream (or volatility) is unrepresentative of the actual capital risk of the strategy.
Implementing and exiting from unconventional monetary policy measures over the past few years has been and will continue to be an experiment. Forward guidance from global central banks suggests one thing is for certain: the environment for fixed income investors will not be as straightforward as it has been in the past. The latest minutes of the Federal Open Market Committee have indicated that QE will be withdrawn as from October 2014, if the current outlook holds.
As is always the case, investors' decisions should be driven their objectives. Exposure to fixed income assets has generally been for some combination of income, total return and of course, diversification. Whatever the objective, note that unconstrained strategies do not provide a sure or complete solution to the current prospects faced by investors. Rather, these strategies offer greater flexibility in their approach to achieving the desired objectives.
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