Core fixed income allocation, usually comprising high-quality government and corporate bonds, has played a relevant role in diversified portfolios over the last few decades. In a 30-year bull market for bonds, this allocation has been a stable source of performance; it has, for a long time, provided interesting income and helped to limit the overall portfolio drawdowns. Investors now stand at a crossroads: changes in central banks’ monetary stances are resulting in the end of the easy money era driven by excess market liquidity. This change will provide, in our view, a fertile ground for active bond investors able to dynamically exploit opportunities in multiple fixed income sectors while it could challenge more traditional and static fixed income allocation approaches.
The end of easy money could trigger opportunities for “alpha”1 strategies; for example, tactical duration management and relative value strategies, within and across yield curves, will be more relevant as interest rate risk rises and market duration stands at historical highs. Searching for income across multiple sectors, including emerging markets, with a dynamic approach, will also be key to exploiting yield opportunities in a rising rate environment. Corporate bond selection will make a difference, as conditions in credit markets are becoming more mature, with spreads already quite tight across the board. Currency dynamics will also be relevant as an additional source of returns, showing low correlation with traditional asset classes, and as a variable to consider when investing in global markets.
Liquidity risk management should be at the forefront of investor priorities in the new investment landscape. In fact, this risk could re-emerge with worsening liquidity conditions in the market amidst CB balance sheet reduction. Being able to play opportunities across the liquidity continuum, maintaining sufficient liquidity buffers, tactically allocate to government bonds for liquidity purposes or further enhance diversification with liquid strategies, such as currency alpha strategies that carry no credit and liquidity risks, will be a major competitive advantage in our view.
As we enter this new market environment, it is critically important for investors to reassess the role of their core fixed income allocation and the key objectives that this allocation should accomplish. In a world in which a one-size-fits-all approach is no longer suitable, investors should build a core bond allocation based on their specific needs. Some investors, for example, have a strong focus on income generation, but also want to ensure that this allocation provides diversification benefits vs the equity component of their overall portfolio. Other investors are currently more concerned about the capital preservation feature of their bond allocation and the total return potential that it can offer. Consequently, we believe that investors should rethink their core fixed income holdings to embrace a more flexible approach that could combine different active investment solutions with the aim of targeting specific investor objectives. This “new” enhanced core allocation should rely on a well-diversified core allocation while also considering some allocation to dedicated “goal-based core building blocks” (ie, income or diversification).
This approach would not only would allow for the better building of a strategic risk/ return/diversification profile regarding core fixed income allocation, but it would also provide flexibility. In fact, it would allow to dynamically change the core allocation over time in accordance with investor objectives and market conditions (eg, tilt more to diversification if the environment were to become more risky or to income if an investor’s income needs were to increase).
Vincent MORTIER,
Deputy Chief Investment Officer
1. Alpha: The additional return above the expected return of the beta adjusted return of the market; a positive alpha suggests risk-adjusted value added by the money manager vs the index. Beta: Beta measures an investment’s sensitivity (volatility) to market movements in relation to an index. A beta of 1 indicates that the security’s price has moved with the market. A beta of less than 1 means that the security has been less volatile than the market. A beta of greater than 1 indicates that the security’s price has been more volatile than the market.
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