My trainer at the gym says that being fit as I get older is all about the "core." With a strong core we decrease the chances of another muscle group - particularly our back muscles - from getting overly exerted. It turns out a strong core does provide a solid foundation, and it was pretty good advice. The investment world might do well to listen to some ideas about the condition of its own core.
We believe certain foundational principles about fixed income have become obscured over time by the trend of falling interest rates, and that a reversal of that trend toward rising rates could pose significant risks to investors.
Fixed Income Has Its Own Core
Duration risk in fixed income is the risk related to the sensitivity of bond prices to interest rate changes, which can have a significant impact on the value of bonds sold prior to maturity. As rates go up, bond prices decrease, and vice versa. The first Blue Paper in this series, Traditional Asset Allocation: The Emperor Has No Clothes, illustrated the role interest rate duration played in a balanced portfolio over the past 30 years of declining rates. With those trends poised to reverse, we believe now is the time to start re-thinking risk and the way we construct our fixed income portfolios.
This focuses on revealing more about those risks, uncovering the limitations of traditional fixed income asset allocation techniques, and helping build a more effectively diversified fixed income allocation. Specifically, this paper concentrates on just one part of the fixed income allocation: the core.
We begin with a simple starting point: a 60/40 portfolio of stocks and bonds - a typical balanced portfolio. Of course, a portfolio's weighting of stocks and bonds reflects each individual investor's risk tolerance and financial goals. Many investors already think about their fixed income allocations similarly, employing a core/satellite approach to building their fixed income portfolio.
The core/satellite approach can be very effective for investors because it makes for an easy distinction between two very different types of allocations within fixed income: the core allocation, which has historically been the true diversifier to equities, and the satellite allocations, which seek higher returns and greater income potential (though with greater correlation to equities, as we shall see) by taking on different risk in additional sectors.
Because this paper focuses on the core, or foundation, it is important to take a step back and understand the kind of diversification the core should provide.
Asset Class Returns in Normal Vs. Stressful Markets
In virtually all time periods when the S&P 500 Index has sold off, correlations have increased. Put another way, when volatility has risen systematically across all asset classes, correlations have usually gone up, and the benefits of diversification down. To illustrate this point, the following two graphs depict the returns and correlations of fixed income asset classes to the S&P 500 during four equity sell-offs within the last 20 years. The four periods are examples of equity sell-offs that occurred as the result of systemic- or economic-driven events.
The first graph compares the performance of the S&P 500 Index against common sub-components of the Barclays Aggregate Bond Index along with the Barclays High Yield and Emerging Market specific risks appropriately. It shows what investors actually earned for bearing the additional risk bond indices. The returns shown are "ex" (without) duration1 of these spread sectors over time relative to Treasuries, also known as excess return over Treasuries. In stressed markets it's common thinking that in these types of markets, portfolios should benefit from diversification.
*Long-Term Capital Management was a management firm that utilized absolute-return trading strategies and high financial leverage. LTCM collapsed mid-year 1998, which led to a Federal Reserve bailout in Sept. 1998. Chart source: Barclays POINT and Pioneer research. For illustrative purposes only. Not all time periods or market factors are shown. Data represents past performance and is no guarantee of future results. Indices are unmanaged and their returns assume reinvestment of dividends, and unlike Fund returns, do not reflect any fees or expenses. It is not possible to invest directly in an index.
By allocating across these standard asset classes, one might have expected great benefit from diversification. However, as this graph illustrates, the real source of diversification didn't come from the different sectors, but came from high quality duration, provided by only one asset class: Treasuries.
During these risk-off scenarios, only Treasuries were negatively correlated to equities. Without duration, all other fixed income asset classes shown above posted negative returns along with equities. It is clear that using anything other than high-quality interest rate duration to diversify did not work in these extreme market environments.
The second graph highlights how fixed income asset classes behaved alongside equities not by performance, but by correlation. This is key because we want to know how the assets in our portfolio have moved in times of elevated financial market volatility when equity markets declined significantly. Of course, as in all cases, past performance is no guarantee of future results, but in these instances, only Treasuries provided diversification.
In normal ("unstressed" or "non-bear") markets, the correlation among fixed-income asset classes and equities has historically ranged between .35 and .50, with the more equity-like asset classes such as High Yield and Emerging Market Debt having the higher correlations.2 In other words, when the equity market moved in one direction, there was only a 35-50% probability that these asset classes would move in the same direction. This means there are many outcomes in which these assets could provide diversification benefits during unstressed markets. Correlations during stressful periods, however, tended to be much higher, which potentially diminishes their diversifying capability.
When Diversification Is Needed Most
The preceding correlation graph shows that during stressful time periods certain non-Treasury assets in the market became highly correlated with equities, regardless of how unlike equities they appeared during normal times.
There is a good reason that assets with strong returns in the long-term have been highly correlated with equities when risk is elevated. In the long run the majority of a well-structured portfolio's returns came in the form of compensation for bearing forms of market risk (volatility risk, default risk, etc.). Those market risks have typically been highly correlated to overall economic activity (and therefore to the investor's own financial needs).
Crucial Questions in Portfolio Construction
Now that we recognize there are varying degrees of equity risk inherent in all non-Treasury securities, we can begin to address the questions that really matter when it comes to portfolio construction:
1. What level of return might I expect by investing in a particular portfolio?
2. How much volatility (defined by both standard deviation and drawdown risk)3 might the portfolio experience in order to earn that potential return?
3. What will the portfolio correlation look like under normal conditions and during elevated periods of market stress? Can we understand the source of its diversification so that when we potentially need diversification the most, we have it?
This is a hypothetical example and is for illustrative purposes only. Not meant to represent performance of any Pioneer Investments product.
Back to the Future
For the past 30 years, because of falling rates, there has been little incentive to separate the risks embedded in a fixed income portfolio with such granularity. Many investors simply added riskier fixed income instruments as they became available without considering the potential interaction between the two distinct parts of the security: the interest rate component and the credit spread component.
However, we think it's important to recognize this widely shared view: Declining inflation expectations induced a sustained downward trend in interest rates that is unlikely to be realized again in the future. Given this, we believe we must once again start thinking about the role our core fixed income allocation should play and be more discerning about what constitutes a core holding.
In a way, we have to go back to the past to get a sense of what may happen in the future. We would have to go back to the 1950s to find a rate environment like today's. The simplicity back then of available securities in the fixed income market made the role of fixed income easy to understand: It was about safety.
In the late 1970s, it became clear that "safety" came from having high-quality duration in a fixed income portfolio; in other words, Treasuries. And we think there is no reason to abandon that practice. It has provided reasonable levels of income and returns historically negatively correlated with equities. Despite the low level of interest rates, in a real flight- to-quality scenario where investors seek high quality assets, duration should still provide a modest benefit.
Understanding the Role of a Fixed Income Allocation
We do not want to abandon interest rate exposure completely because we know it is the only part of a typical portfolio that has historically held up well in periods of extreme market volatility. A significant part of a typical core allocation must maintain duration, which is why many core allocations are benchmarked to an intermediate bond index like the Barclays Aggregate Bond Index. But if duration is more risky than it used to be, the question we need to ask ourselves is rather simple: How can we attempt to get a complementing source of diversification in our portfolio that is not completely tied to interest rates? Our answer is: Strategy allocations.
Adding Strategies, Not More Assets
We've established that stressed-market correlations can differ considerably from average (or normal non-bear market) correlations across asset classes. As such, we believe investors should consider an allocation to intermediate, high-quality bonds in order to help diversify equity risk in a crisis. With interest rates at current levels we no longer can realistically expect the same benefits from that allocation in normal markets as we have observed historically.
That is why many investors have started to take cues from what institutional investors have been doing for years: allocating to strategies rather than just to asset classes.
Uncorrelated Trading Strategies
Instead of basing a portfolio on a benchmark composed of various asset class allocations, a strategy-based approach is centered on market-neutral positioning. In fixed income, this approach seeks positive returns from uncorrelated trading strategies such as global macro, long/short and different forms of fixed income arbitrage - each of which has returns that have not been reliant on the direction of any fixed income or equity market risks. It is important to note that portfolios managed to seek market-neutrality in their positioning may exhibit unexpected correlations as market conditions change.
Generally, each strategy seeks to be less sensitive to market risks and to extract returns exclusively from the relative mispricing of securities. For example, currency long/short (a component of global macro) attempts to capture price gains from the convergence in price of two currencies whose relative price movements may have little to do with domestic economic conditions. Trading strategies like these are important components of an investment portfolio's foundation, particularly in market conditions, such as we're experiencing now, when traditional fixed income asset classes may not offer compelling value.
What Goes Up Must Come Down
For decades, these strategy allocations have been primarily used by institutional investors. Broader use by other investors requires some re-thinking of portfolio flexibility and risk management. In particular, investors using this approach need to consider allowing their portfolio to go both long and short market risks. The asymmetry of fixed income investing, generally a headwind for long-only managers who must own the impact on their holdings of a bull or bear market and cannot actively short market risks, can actually be an opportunity for managers who employ these strategies.
The Price Action "Trap" of Long-Only Investing
Once investors become comfortable with strategies as being a combination of long and short positions, we believe their view of traditional asset allocation will likely change as well. The perspective becomes inclusive of three distinct positions - net-long, neutral, and net-short - as opposed to long-only market risks alone.
Consider the high yield market as an example. A traditional long-only high yield asset manager may try to add value by buying at low prices when spreads are wide (e.g. after a market correction). If timed correctly, the resulting holding period can coincide with strong equity market performance. Conversely, when prices are high and spreads are low, the long-only manager may reduce exposure but may still be long. The resultant negative price action is likely correlated with a bear market in equities. In this case, because he or she is always long, the manager must simply bear the negative price action. On the other hand, strategies that selectively short market risks that are vulnerable to negative price shocks present a much wider opportunity set and a different risk profile.
Achieving Asymmetry Through a Wider Opportunity Set
This wider opportunity set results from the aforementioned asymmetry, and the strategy seeks low correlation in the long run. The ability to be short market risk when it offers little compelling value as part of the core fixed income allocation is what may enable it to exhibit negative correlation to equity markets in periods of extreme market stress, when it is needed most. Contrary to the objective of traditional asset allocation, a strategy-based approach takes on market exposure when the market is compensating for such risk. When compensation is not forthcoming, no exposure is taken. These portfolios, then, should remain uncorrelated with traditional market risks.
Minimizing Drawdown Risk Through a Strategy-Based Allocation
Another key component of the liquid alternative portfolio is a risk management approach that limits the drawdown risk of traditional market exposures. This was covered extensively in the first paper in this series. To recap, drawdown risk can generally be defined as an investment's peak-to-trough performance (from recent highs to subsequent lows).
Drawdown risk management differentiates a strategy-based fixed income allocation from the traditional fixed income allocation. It does not attempt to just buy and hold when betting against the market appears less risky (i.e. "beta is cheap"), ignoring any volatility along the way. Instead, any opportunistic exposure to market risk is automatically paired with trading strategies that seek to limit loss associated with a downturn in that particular market. In this way, the portfolio can be more protected against any large unforeseen drop in value and helps preserve the low correlation - again, when it is needed most.
The House That Fixed Income Built
Imagine your fixed income portfolio as a house modified over many years. The house was originally built with simple investment grade corporate bonds atop a solid foundation of Treasuries (duration). With declining interest rates, Treasuries performed exceptionally well. There were always risks, but the house's foundation was adequate.
Over time, the size of the house expanded considerably. We added more rooms in the form of investment-grade asset classes that sought higher returns. We then built upwards allocating to even riskier assets such as high yield bonds, emerging market debt and bank loans to seek still more returns. So long as interest rates declined, which they did for a very long time, we believe the price appreciation masked the inherent volatility of riskier fixed income "satellite" asset classes. It was all done without any consideration to the stress placed upon the foundation.
As we face a potential shift in the direction of interest rates, it's time to reexamine the stability that our fixed income allocation can provide. To create stability, I believe we need to reinforce the foundation with strategies that have the ability to be uncorrelated to traditional fixed income risks.
Complementing Traditional Fixed Income With Liquid Alternatives
We believe the building blocks of a new and better core allocation to fixed income are composed of both a traditional and a liquid alternative allocation in an effort to be uncorrelated to market risks. Their combination results in a portfolio that seeks to opportunistically engage three different market outcomes: a bearish market with general spread widening; a stable market with low volatility and low spreads; and a bullish market in which spreads tighten significantly. (Wider spreads typically represent riskier markets and narrow spreads less risky markets.)
Summary - Coming Full Circle
My goal for this paper was to help you better understand and manage the risks in your fixed income portfolio. So, let me recap the two major hoped-for takeaways:
- Fixed income assets are a combination of equity-like risk and duration
- Duration is what has historically provided diversification benefits
We believe these two related concepts are vital to understand, perhaps never more so than today. Interest rates at multi-generational lows are forcing many investors into greater allocations to the riskier parts of the bond market, and even into dividend-paying stocks, in the search for income. In isolation, the decision to add more yield-oriented equities and increase the satellite allocations in fixed income can be reasonable so long as it is in the context of a diversified portfolio and investors understand that yield is an excellent proxy for risk.
Avoid More Risk
I become especially concerned when the same investors who are allocating more to the riskier parts of the bond market also are abandoning duration by reducing exposure to intermediate bond portfolios because they are concerned about rising rates. When the addition of what we call "equity-like risk" (in the form of higher yielding fixed income and equity allocations) is combined with a lack of duration exposure, the investor can be viewed as "doubling-down" on equity risk. Investors need income, but having equity-like risk in your portfolio, or adding more, without addressing the core can be increasingly risky. Quite simply, abandoning duration without a reasonable replacement is not an answer.
Strengthen Your Core
All investments carry risks, and there can be no guarantee of future results. But, your core fixed income allocation should be a potent part of your overall portfolio at diversifying equity risk. To help achieve this, uncorrelated trading strategies can be added alongside traditional intermediate-duration bonds to reinforce the foundation of a core allocation. We believe that removing a portion of the duration, not abandoning it completely, can be advisable if it is replaced with an allocation to similar-risk alternatives that have the ability to deliver uncorrelated returns. This approach goes beyond re-engaging the diversifying function of a traditional fixed income core portfolio - negative correlation with equities - to potentially help protect your portfolio against an inevitable rise in interest rates.
Important Information: The views expressed in this memorandum regarding market and economic trends are those of Pioneer Investments, and are subject to change at any time. These views should not be relied upon as investment advice, as securities recommendations, or as an indication of trading intent on behalf of any Pioneer investment product. There is no guarantee that market forecasts discussed will be realized. There is no guarantee that these trends will continue. No forecast is a guarantee.
The performance data quoted represents past performance, which is no guarantee of future results.
Investors should consider risk tolerance and time horizons prior to making investment decisions. This material is not intended to replace the advice of a qualified attorney, tax adviser, investment professional or insurance agent. Before making any financial commitment regarding any issue discussed here, consult with the appropriate professional advisor.
Neither Pioneer, nor its representatives are legal or tax advisors. In addition, Pioneer does not provide advice or recommendations. The investments you choose should correspond to your financial needs, goals, and risk tolerance. For assistance in determining your financial situation, please consult an investment professional.
1.) Duration - A measure of the sensitivity of the price (the value of principal) of a fixed income investment to a change in interest rates, expressed as a number of years. "Ex" duration is the excess return or returns that exceed a benchmark or index with a similar level of risk.
2.) Correlation - The degree to which assets or asset class prices have moved in relation to one another. Correlation is expressed by a correlation coefficient that ranges from -1 (never move together) through 0 (absolutely independent) to 1 (always move together).
3.) Standard Deviation - A statistical measure of the historical volatility of a portfolio; a lower standard deviation indicates historically less volatility. Market Drawdown is a measure of an investment's financial risk as the percentage change of the peak-to-trough decline over a specific period of time.