By David Saunders
For a generation or more, investors have come to know the fixed income portion of their portfolio allocation as a shelter from the proverbial storm—a perceived “safe-haven” investment. Barring a default, a rare event usually reserved for the lowest-quality credits, bonds have been a source of diversification from riskier assets. They are generally investments that deliver capital preservation, income, and a source of stability for conservative portfolio construction.
However, traditional long-only benchmark-constrained bond allocations may not be as reliable as they once were. Fixed income markets will face many factors and challenges in the near future. In fact, there are two primary reasons, in our opinion, for why this market is perhaps more uncertain today than it has been in a generation or more.
Contributing to the uncertainty, central bank monetary policy looks poised to remain a meaningful driver of market behaviour for years to come; we believe global yields may stay low for a substantial length of time; and although the US Federal Reserve raised short-term interest rates at the end of 2015, going forward we do not know how fast or how much higher they will rise (and whether or not they will move in tandem with long-term rates). All of these factors are likely to create challenges for fixed income investors, particularly traditional long-only benchmark-constrained strategies that are already struggling to generate meaningful returns in the current low-rate environment.
A decade’s long, secular, fixed income bull market appears to be coming to a close, and uncertainty looms. While investors will have different objectives for their fixed income allocations, the common thread will be a need for increased agility and flexibility of approach in the face of these macroeconomic headwinds.
Central to that flexibility, in our view, is to consider an allocation to alternative, or hedged fixed income strategies. These strategies can serve as a good diversifier for traditional bond portfolios, and as a tool to better mitigate interest rate risk and credit risk.
Hedged fixed income strategies seek to deliver a return stream that is uncorrelated to traditional fixed income and equity markets. Looking at the data, these strategies have historically been successful in having had low correlation to traditional fixed income performance, as well as improving the return potential of portfolios without significantly increasing risk.
In addition, hedged fixed income strategies have shown strong historical performance while helping to mitigate losses on average in periods of negative performance for investment grade credit and high yield bonds. Over a 20 year period to 31 December 2015, hedged fixed income strategies exhibited an average downside capture of -35.33% versus investment-grade credit.
The fixed income landscape is changing and presenting investors with new risks and opportunities.
The path of interest rates is unknown, we believe the need for diversification and returns will continue to make fixed income investing relevant. In our view, alternative credit is an evergreen proposition. As long as there are risks in portfolios, many investors will continue to look for ways to diversify and create differentiated return streams.
From new types of instruments to more accessible global markets, there are more ways than ever to express investment views, capitalise on potential opportunities and seek to protect against risks.
We see hedged fixed income strategies as a meaningful component of this new paradigm in credit investing.
David Saunders is founding managing director of Franklin K2 Advisors.
