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Q & A: Kathleen Gaffney,Co-Director Diversified Fixed Income Group
Eaton Vance Management

How are the challenges of the next 20 years likely to differ from the past 20 for fixed- income investors?

If there were ever a “Goldilocks” period for fixed-income investing, the past 20 years deserve the label. With interest rates on the 10-year Treasury note falling by more than half, a passive allocation to the Barclays U.S. Aggregate Bond Index (the Barclays Agg) would have had a 5.6% annual return for the 20 years ended June 30, 2015. It would have been difficult for institutions to not meet typical fixed-income return targets.

The same certainly can’t be said for the next 20 years, as markets are weaned from years of central bank-managed, zero-interest-rate policies. The 10-year U.S. Treasury note is in the 2.3% range and the Barclays Agg about 10 basis points higher than that – an income level that falls short of what most plans require from their bond allocation. In addition, if the longer end of the yield curve rises, the 5.6-year duration of the Barclays Agg makes it vulnerable to capital losses.

What adjustments can investors make for this scenario?
We believe that the next 20 years will require a change in the “core-satellite” model that permeates the institutional world today. This has Core and Core Plus strategies at the center, augmented by rotation in sectors such as high yield, emerging markets, preferred stock, floating-rate loans and alternative investments.

Going forward, we recommend a shift in which fixed-income allocations are driven by manager style, not market sectors – a risk-based, “unconstrained” model. The building blocks overlap to a large degree with what exists already, but with fewer constraints and more active risk, giving managers the potential to help plans meet fixed-income targets.

What are the shortcomings of the “core-satellite” model?
Without the broad tail wind of falling rates that managers have had in the past, they will need to be nimble in quickly switching risk exposures. But the core-satellite model imposes inefficiencies, with legacy architecture that was not designed for this new reality. For example, a fixed-income manager with credit expertise in both high-yield bonds and floating-rate loans may see relative valuation discrepancies between those sectors and wants to swap into high yield. But that manager may only be responsible for floating-rate loans, while high-yield management resides elsewhere in the plan. Thus, the optimal trade cannot be made in a timely manner.

How does the unconstrained model change this?
It works by breaking down the artificial sector walls and is aligned instead by management style and expertise. Some or all of Core and Core Plus would be replaced by total return and absolute return strategies. Total return gives managers the freedom to rotate among a wide array of bond sectors that go beyond those in the core-satellite model, with broad latitude to manage duration. Absolute return managers have similar freedom, using long and short positions to pursue steady income and low volatility, with little correlation to equity or fixed-income; typically, they are benchmarked to cash. The unconstrained model would also have a passive allocation to long U.S. Treasurys for “tail risk” protection, and for their historical negative correlation with the S&P 500. We envision a blend of active and passive risk that roughly matches the volatility of the core-satellite approach, but with the potential for greater return.

Active total return and absolute return strategies historically have had higher tracking errors versus the Barclays Agg, compared with Core and Core Plus approaches, based on Eaton Vance’s analysis of the Evestment manager database for the 10 years ended June 30, 2015. But we believe that this trade-off is well worth the potential that the unconstrained model offers for investors in achieving their fixed-income targets.

For more information:
Sue Brengle
Head of Institutional
North America
617-672-8540

The views expressed in this insight are those of Kathleen Gaffney and are current only through the date stated at the top of this page. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance strategy.

This article may contain statements that are not historical facts, referred to as forward-looking statements. Future results may differ significantly from those stated in forward-looking statements, depending on factors such as changes in securities or financial markets or general economic conditions.