In order to navigate this lower yield and longer duration landscape, especially in a rising interest rate environment when principal preservation is paramount, having as many tools in the toolbox as possible is beneficial. One of the tools to potentially improve the risk/reward profile of a portfolio is having the ability to utilize an expanded opportunity set of securities that reside outside of traditional fixed income benchmarks.

The current risk/reward profile in the bond market is skewed more toward risk than reward.  Since yields are historically low at a time when durations are historically high, benchmark tethered fixed income investors and passive fixed income indexers are being compensated less for taking on more interest rate risk.  This diverging trend of yield versus duration is shown below with the Bloomberg Barclays U.S. Aggregate Index.

Source: Bloomberg Barclays Indices.

In order to navigate this lower yield and longer duration landscape, especially in a rising interest rate environment when principal preservation is paramount, having as many tools in the toolbox as possible is beneficial.  One of the tools to potentially improve the risk/reward profile of a portfolio is having the ability to utilize an expanded opportunity set of securities that reside outside of traditional fixed income benchmarks.  There are many segments of the bond market that are not included in widely utilized fixed income indices, like the Bloomberg Barclays U.S. Aggregate Index.  Having the flexibility to actively invest in these non-benchmark securities allows for more opportunities to potentially enhance income generation and provide greater protection against rising interest rates.  As shown below, many of these securities like preferreds, high yield corporate bonds, bank loans, and collateralized loan obligations (CLO), currently offer attractive levels of income with lower levels of interest rate sensitivity.

Source: ⁽¹⁾Bloomberg Barclays Indices; ⁽²⁾ICE BofAML Indices; ⁽³⁾SPDR Blackstone Senior Loan ETF; ⁽⁴⁾J.P. Morgan Markets.

Higher yields like this typically come with additional risks and simply chasing yield is not a prudent investment strategy. Investing in these non-benchmark securities requires the proper macroeconomic and credit research capabilities and, in our opinion, are best utilized in actively managed strategies.  Tactical allocations in these securities during different economic and credit cycles can allow investors to take advantage of opportunities that cannot be captured by conventional benchmark securities.  In today’s environment, when the economy continues to recover and the Federal Reserve edges closer to tapering, interest rate risk can be more prominent than credit risk.  Many of these securities are structured with callable and/or floating rate features, giving them a shorter duration profile, which is advantageous when interest rates are rising. 

Some non-benchmark securities can also help reduce market beta.  Investing in securities that move in the opposite direction of more duration sensitive securities can provide greater diversification within a fixed income portfolio.  High yield corporate bonds, bank loans, and CLOs have exhibited negative correlations versus the ten-year Treasury over the last seven years, as shown in the analysis below. 

Source: ⁽¹⁾Bloomberg Barclays Indices; ⁽²⁾ICE BofAML Indices; ⁽³⁾SPDR Blackstone Senior Loan ETF; ⁽⁴⁾J.P. Morgan Markets.

There was a time when many of these non-index segments of the bond market were only available to qualified institutional buyers (QIBs) and large investors due to their 144A designation and/or large minimum investment size.  Currently, mutual funds and ETFs exist for many of these market segments.  As a result, investors that are not able to purchase these types of bonds directly can now participate and receive ample diversification and sufficient liquidity. 

Expanding the investment opportunity set can be a powerful tool in the toolbox.  With all the downside risks currently in the bond market as interest rates recently hit all-time lows, being restricted to only investing in bonds that are in traditional indices is not ideal.  Having additional sources of incremental return can potentially improve the risk/reward profile of a fixed income portfolio. 

 

The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance.  The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.