Why Adopt an Unconstrained Approach to Fixed Income?

Arif Husain,
Head of International Fixed Income at T. Rowe Price
Portfolio Manager for the T. Rowe Price Dynamic Global Bond Fund 

The past twelve months have provided a sobering reminder that volatility can strike at any time. The slump in commodity prices, persistent low or negative yields, China’s slowdown and intense speculation about central bank actions have made for a highly uncertain period for the global economy—and very jittery investors. Then last month, the UK unexpectedly voted to leave the European Union, sending markets worldwide into a violent tailspin. Volatility looks set to persist for some time to come.

At the same time, traditional income sources are not delivering in the current low rate environment. For example, the Australian government bond rate and 12-month term deposit rate have both moved below 2%1 during the past year. So in addition to downside risks, investors also face significant challenges in finding income.

In a low yield, high volatility environment such as this, traditional benchmark-based approaches are less effective. It is therefore important for bond investors to review their existing fixed income allocation to assess whether it provides them with enough freedom to both minimize risks and profit from relevant opportunities wherever they arise. Achieving this means adopting an unconstrained approach that considers the full spectrum of the fixed income universe, including government bonds and credit instruments, and countries that are less correlated to major markets. 

The good news is that fixed income investors today have more choice than ever before. In countries where interest rates are rising, for example, steepening yield curves can offer income opportunities, while rising volatility on foreign exchange markets can lead to currency opportunities. Emerging markets can offer the higher yields that investors look for but may come with added risk, while lower-yielding, less risky securities still offer benefits in a period of highly volatile equity markets. 

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The bad news is that greater choice does not necessarily make the job of fixed income investors any easier, however with more options comes the need for more research, due diligence, and risk management. However, investors who actively embrace this wider opportunity set are ultimately likely to find their efforts rewarded, while those who do not seek access to different country bond markets could miss potential performance enhancement and diversification. 

The ability to capture returns in rising and falling markets through both long and short positions is a key component of the unconstrained approach. During the 30-year bond bull market, investors in traditional long-only fixed income strategies linked to benchmarks such as the Barclays Global Aggregate Index enjoyed strong positive returns as yields fell and prices rose. However, as yields begin to rise again and prices fall, the ability to short certain markets and sectors and capture returns from falling prices will be extremely valuable. 

By adopting an unconstrained bond strategy, an investor can seek value anywhere in the world irrespective of whether markets are going up or down. But this is not an easy strategy to adopt: the heterogeneous nature of the global bond universe means that the choices facing an unconstrained investor are seemingly endless. Success requires conviction - only those positions backed up with a high degree of confidence should be adopted. 

It is important to stress that adopting an unconstrained approach need not come at the expense of quality or bring additional transaction costs - it is possible to retain a high-quality, liquid profile while still being agile enough to manage risks. A portfolio that is not constrained by a benchmark, but still contains the best investment ideas, should fulfill fixed income’s role as a diversifier and a provider of sustainable income and capital preservation. Ultimately, the goal is balance: how to find the right mix between duration, country allocation, bottom-up security selection, and currency preservation to achieve optimal returns while effectively managing risk and protecting the portfolio. 

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1 Source: Factset

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