The last 30 years have been something of a golden age for fixed income investors. As 10-year Treasury yields fell from over 15% to 3%, the typical fixed income portfolio almost kept pace with equity returns with only a third of the volatility. However, with interest rates near historic lows and the prospects of higher rates beckoning, there’s a sense of foreboding that the party might be over. In addition, worries about inflation and an increased emphasis on controlling asset-liability volatility have left many investors questioning their fixed income programs. This article sets out to clarify the challenges to conventional fixed income investing and offers suggestions for how plans should rethink their fixed income portfolios.
The way we were, and why that’s changed
US institutional investors have historically relied on the Barclays Capital US Aggregate Index (or the “Agg”) as their fixed income benchmark. The index is a market-cap weighted mix of Treasuries, agencies, investment-grade credit, agency mortgage-backed securities (MBS), asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS). It gained prominence in the late ’80s and ’90s as investors sought broad fixed income exposure, and market-cap weighting seemed logical given the wide acceptance of the Capital Asset Pricing Model and the popularity of market-cap weighted equity indexes. By the mid-2000s the Agg was the chief benchmark for a large majority of pension and endowment assets.
There are several reasons to question this philosophy. Market-cap weighting remains a powerful concept with solid theoretical footing in the equity space. Investors around the world evaluate all the factors that might affect security valuation, and the market-cap values should represent the consensus optimal portfolio weights. However, while equity investors broadly seek to maximize risk-adjusted returns, fixed income investors have more divergent preferences.
“Some investors want total return, and others want to hedge their liabilities...even the liabilities themselves can vary significantly,” says Al Goduti, a team leader in BlackRock’s US & Canada Global Client Group. “More often than not, the old ‘one size fits all’ fixed income benchmark approach doesn’t appeal to all investors anymore.” In addition, the composition of market-cap weighted indexes is subject to the vagaries of debt issuance. Sector weights can vary significantly based on the relative issuance between government and corporate sectors and the maturity of the debt issued. And changing sector weights vary the risk-reducing characteristics of the benchmark in a way that may be inconsistent with investor objectives.
The fixed income world has also evolved significantly beyond the assets included in the Agg. Investors today can access a comprehensive set of risk premia through a wider range of fixed income sectors.
For example, Treasury Inflation-Protected Securities (TIPS) have been issued since 1997 and offer investors pure real rate exposure. High-yield bonds provide greater return potential with sizable credit and illiquidity risk premia, and bank loans are floating-rate instruments that have gained popularity for their resilience in rising rate environments. Finally, emerging market countries have been increasingly issuing debt in local currencies, offering access to rapidly growing economies. “Overall, today’s fixed income landscape is richer than it has ever been,” sums up Rick Rieder, BlackRock’s chief investment officer of Fixed Income, Fundamental Portfolios. “This evolution offers investors a tremendous amount of flexibility to position their portfolios.”
Back to the drawing board: Three new perspectives emerge
As investors have woken up to the limitations of the Agg benchmark, there has been an increased focus on customization and redesigning fixed income allocations to specific plan objectives. We have seen three main themes:
1) Liability hedging: Changing pension accounting regulations and contribution rules have created an increased awareness of liability volatility, particularly among corporate plans. “The Agg represents a particularly bad fit from a liability-matching perspective,” says Fred Dopfel, head of client strategy for the Americas within BlackRock’s Multi-Asset Client Solutions (BMACS) Group. “It is concentrated in intermediate-duration bonds with much less interest rate exposure than the typical long-duration liability. It also includes sizable allocations to securitized bonds, which behave very differently from liabilities.”
Both these features caused the Agg to underperform plan liabilities during the dot-com crash as interest rates fell and again during the credit crisis as the securitized-bond market imploded. As a result, many plans have moved toward long-duration fixed income indexes—particularly long credit bonds and even credit-screened bonds—in an attempt to better match liabilities and de-risk the plan. Not every investor has explicitly defined liabilities (e.g., endowments and foundations). However, there are often implicit liabilities, and fixed income benchmarks can be designed as risk-minimizing assets that serve as a core portfolio holding.
2) Total return and diversification: Many investors, including those without explicit liabilities and pension plans, see a role for fixed income assets as a source of growth and diversification. The chart below illustrates how investors can capture potentially higher Sharpe ratios by allocating to sectors with greater risk adjusted returns from an asset-only perspective (e.g., intermediate-duration bonds as opposed to long-duration bonds) and increasing diversification across the fixed income opportunity set. Portfolio characteristics are consistent with expected asset class risk premia and historical risks and correlations.
These allocations are meant to be illustrative rather than prescriptive. The “optimal” fixed income portfolio will vary across investors based on their risk tolerance. For example, central banks and corporate Treasuries emphasize capital preservation and may invest more conservatively. Similarly, the fixed income asset allocation decision depends on overall portfolio composition since different sectors have varying correlations with equities and alternatives. “High-yield bonds, for example, are essentially uncorrelated with Treasuries, and a fixed-income-only perspective would suggest large allocations, given their diversification benefits,” explains Kelly Campbell, a member of the portfolio strategy team within the Fixed Income Portfolio Management Group. “But high yield has a significant correlation with equities, and a total portfolio perspective would result in a more tempered view of the asset class,” she adds.
3) Regime-aware investing: In the wake of the credit crisis, many investors recognized the limitations of looking at recent historical returns in determining portfolio diversification since asset class returns and return distributions can be very different depending on the regime. For example, many investors today are concerned about the prospects of rising rates. The chart below illustrates expected returns across fixed income sectors for a 100 basis point increase in rates across the curve, based on historical asset class relationships.
This chart is not meant to be a precise prediction of asset class returns the next time rates rise, but it does illustrate some interesting relationships. As expected, long duration nominal bonds usually generate the worst performance during episodes of rising rates. Rising rates are generally accompanied by more benign economic environments where spreads typically fall, producing better performance in credit and high yield. Emerging market debt has historically outperformed in such environments while floating-rate bank loans are expected to be the most resilient and even to generate substantially positive returns.
“Investors concerned about rising rates may tilt their portfolios toward sectors that provide better rising-rate regime characteristics, but it’s hard to forecast the magnitude and timing of rate hikes,” warns Dopfel. Investors should ensure that the tilts do not result in significantly lower returns in normal (stable rate) regimes and must balance this “cost” of protection relative to the magnitude of the protection sought. And as before, it is important to take a total portfolio perspective and consider the performance and relationships with equities and alternatives in the different regimes.
In an environment of falling yields, as every fixed income investment turned to gold, it was easy to overlook fixed income asset allocation. Unfortunately, those years are behind us now. The use of the Agg as a fixed income benchmark is theoretically questionable and a poor practical representation of the current fixed income landscape. Instead, redesigned fixed income portfolios must begin with a consideration of the investor’s objectives, liabilities and philosophy. Successful investors will evaluate fixed income beta in light of their overall portfolio allocations and use the full menu of fixed income investments to achieve desired outcomes.
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