- The US Core strategy, one of Western Asset’s flagship products, seeks to outperform the returns of the broad investment-grade universe by allocating across all sectors of US fixed-income, including Treasuries, agency mortgages, corporates and structured product.
- Western Asset utilizes a dual approach when managing US Core portfolios by employing both top-down duration and yield curve strategies as well as bottom-up sector and issue selection.
- The US Core strategy is designed to serve as an anchor to windward that seeks to do well in risk-off periods when other portions of a client portfolio may be under stress or underperforming. The strategy’s performance during 2018 emphasized how well a US Core allocation can work within the context of a broader client portfolio.
- Western Asset’s US Core Constrained strategy is designed to offer clients a high level of quality and liquidity within their total portfolios.
- We expect that the US and global expansion will continue in 2019, albeit at a very slow pace, and that central bankers will continue to be accommodative. Such an environment is traditionally good for spread sectors, though we believe a top-down approach coupled with broad sector diversification is critical.
- Looking ahead, we expect to see more demand for fixed-income solutions such as US Core Constrained as investors seek to offset risk elsewhere in their overall portfolios.
How would you describe Western Asset’s US Core strategy to an investor?
FM: Western Asset’s Core strategy seeks to outperform the returns of the broad investment-grade universe by allocating across all sectors of US fixed-income, including Treasuries, agency mortgages, corporates and structured product. We utilize both duration and yield curve strategies as well as make active allocations to the investment-grade sectors where we see the best value. Western Asset’s dedicated sector teams look for outperformance in their individual security selection, which is also an important component in the overall returns to the strategy.
How would you expect an investor to use the strategy within a broader portfolio?
TC: Within a fixed-income allocation, the Core strategy is designed to offset risk in a client’s overall portfolio, whether that’s from equities or alternatives, or from higher risk sectors within fixed-income. Our US Core strategy is designed to offer a high level of quality and liquidity while also providing a level of current income for investors. We believe the strategy is meant to serve as an anchor to windward that can do well in risk-off periods when other portions of a client’s portfolio may be under stress or underperforming.
In what ways does Western Asset’s approach to its US Core strategy differ from that of similarly positioned products?
TC: If we compare our Core strategy to similar strategies of our competitors, we’re alike in that we are all allocating to the same areas within investment-grade dollar-denominated fixed-income. We, too, are investing in Treasuries, agency mortgages and investment-grade corporate credit. Where we differ is in that we utilize both bottom-up and top-down macro strategies in an effort to generate attractive returns while also approximating the risk profile of the strategy’s benchmark. Some competitors look to just hug the benchmark from a duration and yield curve perspective and then add a little bit of value through issue selection. Western Asset’s track record, however, reflects our dual approach. We’ve been managing Core portfolios for close to 40 years and have built our name and business on our active use of duration and yield curve positioning as well as our issue and sector allocation.
Do you consider Western Asset’s US Core strategy to be the same as its US Core Plus strategy, just without the “Plus” sectors?
TC: We consider Core to be a distinct strategy from Core Plus, particularly from a risk perspective. While Core Plus is designed to have both a higher risk budget and alpha target, Core is managed in a much more conservative manner. Our Core strategy targets roughly half the tracking error and half the alpha target of our Core Plus strategy. When sizing positions for portfolios managed to our Core strategy, our portfolio managers are mindful that it’s meant to be much more conservative than the Core Plus strategy.
FM: We employ the same overall market outlook for both our Core and Core Plus strategies but given the differing risk parameters, sector allocations will vary which, in turn, results in differing curve and duration strategies as well. That’s because we use our yield curve and duration strategies in conjunction with sector allocations for both. Because our Core and Core Plus strategies have different sector allocations, they are going to have different curve and duration strategies as well.
Fred, how do you and the rest of the team decide upon the initial construction of a US Core portfolio? What is the process for then determining a change in positioning for a portfolio and from there, how do you go about implementing that change?
FM: The macro and sector strategies in a US Core portfolio revolve around the investment outlook developed by the Firm’s US Broad Strategy Committee which really sets the risk tone for US portfolios. From there, other Core portfolio managers and I meet regularly with the rest of the broad market team to discuss these outlooks and decide on our specific sector weights. We also discuss where we want to be positioned on the yield curve and with regard to duration. This active dialogue is what generates our relative exposures to the benchmark and explains why we have consistency in our positions across portfolios of the same mandate. As our outlook evolves and we consider making changes to either the sector allocations or curve strategies, we seek to implement that change across all portfolios for that mandate. We make changes to portfolio positioning in response to a change in our expected returns in a sector which can either be because of a change in underlying fundamentals or a change in valuations. While the Core portfolio managers will decide on changes in sector allocations, we then ask our sector teams to implement these changes and determine where they see the best relative values by subsector and issuer.
Can you give any examples of recent portfolio positioning changes made across US Core accounts?
FM: Over the last few quarters we have reduced our exposures to structured product, not because we had a particularly negative outlook on the sector but because we saw that yields had narrowed quite sharply relative to other investment-grade sectors. Spread tightening was the motivation for reducing our exposure to commercial MBS and ABS. We essentially chose to reallocate the risk in our portfolios away from a sector that had performed well and into other sectors that now look to provide relatively more value.
What does the expected risk profile of this strategy look like? How would you expect it to perform in periods of low volatility and in periods of high volatility?
TC: For a generic US Core account, our long-term expected tracking error target is roughly 150 basis points (bps). Given the risk profile, such an account will naturally be a very high quality portfolio with a lot of high quality duration coming from Treasury and agency mortgages as well as from investment-grade corporates.
I think 2018 was a really good example of how our Core strategy can perform in times of volatility and why it can be such an important component of an investor’s broader portfolio. Early in 2018, we had a risk-on environment where US equities and spread sectors were doing very well and then we hit a pocket of volatility. This was clearly evident at the end of 2018 when some equity indices were down over 20% from their highs and ultimately ended the year in the red. During that period of heightened volatility, our Core portfolios did what they’re expected to do—they generated positive returns as yields declined during a flight to quality. As the US Aggregate Index ended the year roughly flat, it demonstrated relatively good performance in comparison to equities and a bit of a hedge to volatility. Reflecting on 2018 really shows how well a Core portfolio can work within the context of a broader client portfolio and why it’s so important to consider a high quality component within a total portfolio.
How do you manage risk within the strategy, Fred, especially in seeking to achieve performance like Travis just mentioned, during periods when other sectors are experiencing a lot of volatility?
FM: Our sector and rate strategies were created to dampen the risk of the overall volatility of portfolio returns. That is one of the features of using diversified strategies within the portfolio. To monitor that overall risk, we work very closely with our risk team and utilize our in-house Western Information System for Estimating Risk, or WISER. This is our risk system that looks at the expected volatilities of the portfolio returns, both when markets are acting within the historical correlations that we’ve seen recently, as well as looking at expected volatilities when these historical correlations sometimes break down. Overall portfolio risk is something that is an important guideline for our portfolios. We expect it to change over the course of the business cycle, depending upon where we see opportunities, but we always make sure it stays within the constraints of the strategy.
Speaking of strategy constraints, can Western Asset offer versions of the strategy that are managed to different risk targets?
TC: Absolutely. As mentioned earlier, we consider Core to be distinct from Core Plus in light of their very different risk budgets and risk targets. Similarly, even within our Core strategy, we can customize portfolios to target different risk budgets. By its nature, Core is already a very conservative strategy. That said, for many years we’ve been managing a number of accounts within our Core complex that have even tighter constraints than our traditional Core accounts. In many cases they’ll have either tighter duration bands around the benchmark, a higher average credit quality, very limited or no use of derivatives or limited use of some of the spread sectors. Given the increased market interest we’ve seen for lower volatility Core accounts, we’ve recently decided to roll out a new marketed US Core Constrained strategy which consists of accounts we’ve managed that have these even tighter constraints than a typical Core mandate. While a traditional Core mandate may have an expected tracking error target of roughly 150 bps, accounts within our US Core Constrained composite have roughly half that tracking error target, closer to 80 bps. We have the ability to create a highly customized mandate that can target a client’s specific risk tolerance and we can adjust the guidelines to make it an even more tightly constrained mandate than a traditional Core strategy.
How are derivatives used within the strategy, and would the team be comfortable managing a US Core portfolio without the use of derivatives?
FM: Derivatives can be very helpful for both providing exposure to opportunities we see for generating additional alpha and for constraining overall risk in the portfolio. Derivatives can take the form of both Treasury interest rate futures and options as well as credit derivatives. They can provide better trading opportunities, exposure at a lower cost than what we can achieve in the cash bond markets, and provide really unique trading strategies within the portfolio on shorter term horizons. That said, we have and do manage Core portfolios that don’t allow derivatives. These accounts are somewhat more constrained in some of the exposures than those that allow derivatives. So while we prefer to have the ability to utilize derivatives within a Core account, managing without them is something we can do while seeking to meet similar alpha targets. We just have to adjust our cash bond exposures to do so.
Finally, what is your outlook for the US Core strategy?
FM: After a difficult 2018 we think 2019 looks much better for US Core fixed-income investors. Since inflation has remained very close to or below the Federal Reserve’s (Fed) 2% target, we would expect fixed-income yields to remain within the range that we’re now trading. There seems to be little reason to expect Treasury yields will be much higher at the end of 2019 than they are now, and they could even be somewhat lower if inflation remains contained. That said, we expect the US and global economies to still be growing this year at a pace somewhere near trend. Such an environment is traditionally very good for spread sectors, investment-grade corporates, mortgages and structured product should all do well in an environment where the Fed doesn’t have to raise rates much if at all and inflation remains fairly low.
View the Performance and Risk Disclosures for US Core and US Core Constrained.