Enhancing Fixed Income Portfolios with Unconstrained Strategies

Traditionally, many investors have employed a strategic asset mix that is based on, or at least resembles, a common core index, such as the Bloomberg Barclays Global Aggregate Index. However, the current rate environment demonstrates how investors taking this approach may be left especially vulnerable to interest-rate risk, when low interest rates combine with the long-duration characteristics of several common core indices.

The Bloomberg Barclays Global Aggregate Index is used as a benchmark for many fixed income strategies, and the perception is that it is a representation of the broad global fixed income market and general investor sentiment.

Our analysis of the aggregate index highlights several notable risk components that investors should be aware of. These generally fall into four categories:

1. Risk from longer duration.
2. Overexposure to heavy debtors.
3. Sector allocation drift.
4. Correlation risk.

Duration is vital to understanding the nature of the aggregate index; in fact, for an index-based portfolio, duration is the primary driver of performance. Credit risk—the other main driver of returns in fixed income investing—is largely absent from aggregate indices due to their heavy emphasis on lower-yielding, interest-rate-sensitive developed-government issues and agency securities.

In general, for a fixed income security or portfolio, the longer the duration, the more sensitive it is to fluctuations in interest rates. When rates go up, generally the value of these securities goes down more if they have longer-duration characteristics.

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Under certain macroeconomic conditions, an index can become increasingly concentrated in a few large entities, and investors may find themselves with much less diversification than they might have previously assumed.

Historically cheap financing levels have prompted many investment-grade companies to lock in longer-term debt at record-low interest rates, and the aggregate index, like many core fixed income indices, is issuance weighted. As large entities issue more debt, their positions within the benchmark increase. This has another effect as well: increasing the index’s duration and leaving portfolios vulnerable to interest-rate movements.

The perception of the aggregate index is that it is a strongly diversified mix of government and investment-grade corporate issues. However, the composition of the index is actually heavily weighted towards treasury securities, with an approximate allocation of 50% or more. Furthermore, recent years have seen the index’s treasury allocation approach historically high levels at the expense of other assets.

This shift could present problems for investors who may find themselves far less diversified than they might have assumed, leaving their portfolios vulnerable to capital loss or erosion should only a few fixed income asset classes experience a downturn.

Due to a combination of the aggregate index’s composition practices and recent market and economic trends, its correlation to US Treasuries and other developed-market indices has been fairly high.

The high levels of correlation to US Treasuries and other developed-market debt signify two potential problems. Firstly, as Treasuries and other developed-market bonds tend to have low credit risk, this again reinforces the premise that it is duration that is the main driver of performance, which again suggests that the aggregate index, and portfolios that mirror it, carry significant interest-rate risk. Secondly, the high correlations also underscore the lack of true diversification in the index.

The uncertain rate environment of early 2017 has put at risk fixed income programmes with asset allocations that adhere too closely to core indices, making them vulnerable to rising rates and/or loss of portfolio value from low returns and lack of diversification. Unconstrained strategies can invest in securities similar to those contained in the aggregate index, but will often invest selectively in assets such as emerging markets, leveraged bank loans or high yield in order to enhance the yield and manage the risk of a fixed income portfolio.

Learn more about Franklin Templeton’s unconstrained bond funds at: http://www.franklintempleton.com.au/en_AU/adviser/global-bonds-unconstrained