By Jim Caron
Fixed income products have been traditionally used to add ballast to one’s portfolio by creating diversification and reducing risk. Of course, this was more easily done 35 years ago when bond yields were at their peak and declined steadily ever since. But that was then.
Today, using bonds to achieve diversification in a portfolio is much more challenging by virtue of the fact that yields are very low, thus bonds do not produce nearly the income they used to. A balance must be struck between the return required by an investor’s allocation in fixed income and the risk they are willing to accept. But that’s not all, the allocation to bonds must also satisfy the necessary criteria to produce a reliable source of stable income, create diversification and reduce correlation risks across the whole of the portfolio, especially as correlation risks are prone to rise as quantitative easing (QE) benefits fade. A potential solution is to enter into buy-and-hold (B&H) fixed income strategies.
The objective of a B&H strategy is simple: earn more yield while taking less risk. But reaching that objective is difficult because it involves complex portfolio diversification and optimization techniques and extensive research analysis to evaluate the bonds to construct the portfolio with. This strategy is not contingent on trying to time the market and make returns through managing market price volatility. Instead, the investor manages risks associated with default and minimizing that risk. The end result is that the investor in this strategy achieves a higher yield with lower risk.
To achieve this, it is advantageous to deploy a two-pillar approach to structure the portfolio. First, a full quantitative analysis is made of the entire universe of global bonds in order to select a sub-set of securities that satisfies rigorous investment criteria. Next, best practice would be to examine the remaining securities using a fundamental “bottom-up” research technique aimed at identifying and selecting the best segments of the bond market for the portfolio. The advantage of an approach that is not tied to the benchmark is that the portfolio is not oriented to the market, and if a particular market segment is not very attractive the investor is not compelled to take a position in it. This approach reduces correlation risks and can produce more stable returns across an investors overall portfolio.
Since the investment opportunity-set spans a wide range of global fixed income assets, investors must also take into account currency hedging back to the given home currency. The goal of this strategy is to manage credit risk, not take currency risk. So all investments are fully hedged back to the investor’s home currency.
B&H strategies fulfill a specific investment objective over a defined holding period and create alpha by minimizing default risks. This strategy is a good complement to a balanced portfolio that is using fixed income in their broader asset allocation strategy; ranging from individual investors, pension funds, insurance companies and many others.
The B&H strategy is attractive today because we believe it can represent a stable and potentially higher source of income with less volatility and higher predictability of cash flows than otherwise may be the case. In this very uncertain market environment, we believe buy-and-hold strategies fit the bill.
Jim Caron is a portfolio manager in the MSIM Global Fixed Income team
