By Aubrey Basdeo, Rachel Siu
Against a backdrop of rising rates, we suggest 3 key actions for investors to adopt to get the most out of their fixed income portfolio.
2018 has been challenging for fixed income investors. Three quarters into the year, the FTSE TMX Canada Universe Bond Index (Universe Bond Index) has delivered a negative total return of -0.35%, in stark contrast to the average annualized returns of 7% investors experienced over the past 20 years.1
Interest rates are rising as central banks globally remove accommodation in response to faster economic growth and rising inflation. As a result, we believe muted fixed income returns are the new normal. Against that backdrop, we suggest 3 key actions for investors to adopt to help get the most out of their fixed income portfolio: understanding what you own, being active, and staying diversified.
Understand What You Own
The first idea is understanding what you own. That might seem simple and straightforward - investors generally have a sense of what's in their portfolio, whether it's government bonds, corporate debt, or a mix of both. But beyond knowing the sector level view, we believe it's critical in today's environment for investors to dig deeper to understand the risk exposure of their clients' bond investments.
There are two principal risk factors that impact fixed income investments: interest rates and credit spreads. Why does this matter? These risk factors can help investors understand what's driving returns. For example, looking at the Universe Bond Index, the sector breakdown is roughly 70% government bonds and 30% corporate bonds. But from a risk perspective, over 90% of the index risk comes from interest rates, meaning the biggest driver of return is the movement of rates. That worked well in a declining rate environment as bond prices rose but not so much when rates reverse as we've seen so far this year.
This leads to our second action: in today's environment of rising yet still low yields, it's critical to actively adjust the balance between interest rate and credit risks across a fixed income portfolio. An investor can tactically add high yield or emerging markets exposures for potential income (i.e. dial up credit spread exposure) to help offset rising domestic interest rates (reduce duration risk).
In addition to being active, we believe a well-diversified strategy can help bond portfolios weather the rising rate environment. Market events like the sell-off in high yield bonds in late 2015 and the Bank's surprise rate hike in summer of 2017 have shown the importance of avoiding concentrated bets. We believe fixed income portfolios are better served by having lots of little bets, rather than putting too many eggs in one basket. Diversified sources of return can help generate outperformance across different market regimes.
This philosophy is reflected in the actively managed total return solution XSE (iShares Conservative Strategic Fixed Income ETF) which aims to deliver outperformance versus the broad Canadian bond market. The fund tactically allocates to diversified sources of return across global fixed income sectors. This approach has allowed XSE to deliver returns in a more consistent manner, especially during times of greater volatility. Over the past three years, it has delivered cumulative outperformance of 490bps, net of fees, versus the Universe Bond Index.
And crucially, the fund did not load up on credit (or equity-like risk) to accomplish that outperformance - in fact, XSE's 3-year correlation to the S&P/TSX Composite Index and the S&P 500 Index is 0.08 and -0.03 respectively.2 In other words, the fund can also act as a diversifier and ballast to equity risk in an investor's overall portfolio.
1 Bloomberg, as of 9/30/2018
2 Bloomberg L.P. Correlations are based on daily returns in the last 36 months, ending 9/30/2018
This post originally appeared on the BlackRock Blog.