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Defending the Defensive: Protecting Your Fixed-Income Portfolio in a Low Yield World

Michael B. Zelouf
Head of London Operations

Executive Summary

  • Central bank rate cuts, quantitative easing, a subdued global recovery and extraordinarily low inflation have left global bond yields close to record lows. Some sectors still offer value but a divergence from the current benign macroeconomic environment for bonds could see volatility increase.
  • A more flexible active approach utilizing strategies that are not obliged to track traditional benchmarks can provide the latitude needed to defend this ”defensive” asset class and help it serve its purpose to provide income as well as ballast to risk assets such as equities.
  • Traditional active bond management, with the flexibility to underweight duration and overweight sectors that offer value, can cushion price declines during periods of rising rates.
  • Unconstrained fixed-income strategies are designed for investors seeking to achieve their objectives during both bullish and bearish environments for bonds; they also provide the latitude needed to manage risks more nimbly and seize opportunities.
  • Bond investors must carefully consider the role of their fixed-income portfolio before choosing which approach suits them best. It is also important that they evaluate asset managers’ resources, process and track records in managing active and unconstrained fixed-income strategies.


Investors in global fixed-income markets are currently grappling with a challenging dilemma: how to secure a reasonable level of income from bonds while maintaining the role of bonds as a ballast to equities and a tool for capital preservation.

More than 7 years after the onset of the global financial crisis, the global economic recovery is facing uncertainty on a number of fronts, most recently the slowing in China and other developing economies and ensuing weakness in commodities. Low inflation has driven yields on global aggregate bonds to record-lows (see Exhibit 1).

Exhibit 1
Global Bond Yields at Near Record Lows
Source: Bloomberg. As of 31 Aug 15.

Nevertheless, near term, the global economy is expected to remain on a modest recovery path thanks to low inflation allowing central banks to maintain a very accommodative monetary stance and a more robust financial system. This environment will be supportive of spread sectors while government bonds are likely to trade in a broad range.

However, the risks to this benign scenario and implications for bond investors are meaningful. The primary risk is that, in coming years, inflationary expectations (and ultimately inflation) will begin to rise in a belated response to extraordinary monetary stimulus around the world. Such a scenario could see government bond prices fall sharply as markets price in higher interest rates, although credit spreads, over time, should narrow as better growth supports credit fundamentals.

Exhibit 2
Global Government, Household and Non-Financial Corporate Debt
Source: McKinsey Global Institute. As of 28 Feb 15. Note: Data may not sum due to rounding *2Q14 data for advanced enconomies and China; 4Q13 data for other developing economies

A less likely—potentially more serious—“tail” risk is a deflationary stall in the global recovery in which the headwinds of China’s slowing economy and the unravelling of developing economies’ export-driven growth models drag down US and eurozone growth. Weaker commodity prices and a stronger US dollar would raise fears that inflationary expectations could become “unanchored” from central bank policy. Government bonds, especially for longer maturities, would benefit, but credit and other spread sectors could perform poorly given the significant acceleration in both public and private-sector debt issuance since 2007 (see Exhibit 2).

Under both scenarios, bond investors are likely to focus on the downside risks and seek additional flexibility from their bond strategies to protect investments from increased market volatility. Actively-managed, global and unconstrained strategies are therefore likely to perform better than passive strategies in these environments.

How Does the Choice of Bond Strategy Affect Where Portfolio Returns Come From?

Investment portfolio returns can be decomposed into two components: those arising from passive exposure to general market movements as proxied by market indices (referred to as “beta” in this paper) and those arising from factors that cannot be explained by passive exposure to general market movements (referred to as “alpha” in this paper). We are classifying as “alpha” the contribution from the active management of “beta” factors such as duration or sector allocation in this paper. Passive strategy returns are entirely attributed to beta factors, while traditional active bond strategy returns, in general, have displayed an attribution of around 85% to beta factors and 15% to alpha factors1. Unconstrained bond strategies’ return attributions have been more biased to alpha factors and their volatilities have displayed a low correlation to the volatility of equities and traditional bond indices.

Exhibit 3
Sources of Return for Bond Strategies
Source: Western Asset
Exhibit 4
Sources of Return for Unconstrained Global Bond Strategy
Source: Bloomberg, Western Asset. As of 31 Aug 15.

Exhibit 4 shows the results of a multiple regression of the monthly returns of an unconstrained global strategy investing only in investment-grade bonds2 against a number of indices of global bonds and US equities. Over the period analysed (2006-2015), 4.2% of the 5.8% annualized returns achieved (or 72% of the total annualized return) cannot be explained by the returns of the indices shown. The choice of indices used in the regression and the time periods for the analysis may have influenced the level of alpha. Nonetheless, the results demonstrate that unconstrained strategies can provide more scope for generating returns from active management with a volatility that is not explained by that of major market indices.

Passive Bond Strategies

In the current low yield environment, investors utilizing market capitalization-weighted indices for bond portfolio benchmarking need to be aware of the change in the risk-reward relationship of the underlying securities in the index and especially to the potential for principal losses from rising yields. Specifically, as advanced economy government and other investment-grade sector bond yields have fallen sharply in recent years, their duration (price sensitivity to interest rate movements) has risen (see Exhibit 5).

Exhibit 5
Barclays Global Aggregate Index Rate and Duration History
Source: Barclays. As of 31 Aug 15.

The Importance of Active Management and Global Diversification

In a low yield environment, the role of alpha factors becomes significantly more important than that of beta factors as the return-risk relationship for beta is increasingly asymmetric; the scope for managers to generate high capital gains from passively riding falling market yields is much lower than the risk of capital losses that cannot be offset with coupon income.

Key to the avoidance of negative returns in a low yield environment is active management. For benchmark-relative long-only strategies, active managers have the discretion to reduce duration, adopt yield curve flattening positions that benefit in rising rate environments and diversify globally into markets that are at a less mature stage of their interest rate easing cycle. Additionally, managers can augment income by overweighting selective credit sectors or inflation-linked bonds and underweighting government bonds in anticipation of narrower credit spreads or wider inflation breakeven spreads. Finally, active currency strategies can contribute positively to performance and diversify the risks of bond price declines. All these active strategies can help mitigate capital losses in a rising yield environment in a way that passive strategies cannot. Exhibit 6 demonstrates the way in which an active global bond strategy3 has outperformed its index without significant additional volatility compared with its benchmark.

Exhibit 6
Source: Western Asset, Barclays. As of 30 Sep 15.

Unconstrained Investing

Unconstrained fixed-income investing typically seeks to maintain many of the benefits offered by traditional active global bond strategies, including capital preservation, liquidity and risk diversification. There is greater flexibility to achieve these objectives during both bullish and bearish environments for bonds, however, without the need for strategic country, sector or duration exposures represented in a traditional Global Aggregate benchmark.

In a rising rate environment in which markets insufficiently compensate investors for risk, duration can be reduced to zero or even negative levels to protect or enhance returns. Having the latitude to rotate between the government and spread sectors as relative valuations deviate from fundamentals can also offer significant benefits.

Credit markets, in particular investment-grade sectors, over time have offered investors significant positive excess returns relative to their underlying fundamental credit risks: specifically, the extra yield from investment-grade corporates has significantly exceeded the losses from the very low level of defaults. However, from time to time, credit markets are subject to very large principal losses as investors seek refuge in safe haven assets during periods of market shocks, geopolitical crises or systemic financial crises (e.g., in the wake of the Lehman Brothers bankruptcy). Unconstrained strategies have the benefit of tactically using macro strategies (such as duration, yield curve and volatility strategies) to act as a ballast against these risk scenarios and protect portfolio returns without having to sell or buy expensive and often imperfect credit-related hedges.

In unconstrained strategies, more of the return is attributed to alpha factors. Unconstrained strategies tend to have lower correlations to traditional duration and sector beta factors. This is important for two reasons:

  1. It lowers the risk of inadvertent concentration in a specific risk factor, especially if the investor is holding a blend of an unconstrained global strategy alongside a traditional active strategy.
  2. It means that the higher fees accruing to unconstrained strategies go to compensating for manager skill and generally less to passive beta exposure.

Investors have access to a wide variety of unconstrained fixed-income products across the volatility spectrum, seeking positive absolute or total returns over varying time periods. Ultimately, the choice must be a thoughtful one based on the investor’s investment horizon, volatility and drawdown tolerances, liquidity requirements and regulatory constraints on investments. In addition, the primary investment style (e.g., macro driven, credit focused, etc.) used within the unconstrained strategy could be an important consideration, especially when assessing correlations to other asset classes.

Unconstrained strategies offer the flexibility to:

  • Invest only where the manager has strong conviction on fundamentals and valuations
  • Take concentrated positions in sectors or markets that offer compelling value
  • Take short positions in duration or sector exposures in seeking to benefit from periods of price declines

One needs to bear in mind that at times unconstrained strategies may be subject to opportunity risk versus traditional active strategies that would have structurally longer duration. However, this is typically compensated by the opportunity for higher returns both in absolute and risk adjusted terms over a market cycle.

How Are different Strategies Likely to Fare in the Future?

Our fundamental outlook and risk scenarios for the next 1 to 3 years are summarized in Exhibit 7.

Exhibit 7
Outlook and Risk Scenarios in next 1-3 Years
Source: Western Asset

In our base case scenario in which rates remain “lower for longer,” a strategy that passively mirrors an index such as the Barclays Global Aggregate would be very limited in its ability to generate high levels of total return due to its requirement to hold a significant allocation to the low yielding markets dominating the index. Actively managed benchmark-relative strategies could generate positive excess returns to the index from overweighting credit and selected emerging markets. The magnitude of excess performance should broadly be in line with the amount of tracking error volatility discretion that could be employed.

In our primary risk scenario, in which inflation expectations rise, passive strategies would be negatively impacted by the rise in yields that would likely impact most the core government markets. Actively managed and globally diversified strategies could again generate positive excess returns to the index by underweighting duration and low yielding markets. However, total returns would likely still be negatively impacted by the rise in yields.

Conversely, in our secondary risk scenario, in which the global recovery stalls, passive and actively managed benchmark-relative strategies would be expected to generate positive returns. In an environment in which equities and credit sectors perform poorly, these strategies would be cushioned by strength in longer duration, liquid government bonds that would benefit from a “flight to safety.”

Our estimates of the broad ranking of total returns under each of the scenarios over the next 12 months for each of the investment approaches are approximated in Exhibit 8.

The estimated return rankings in Exhibit 8 indicate that the different bond strategies may behave differently under various scenarios and that benefits can accrue from increased flexibility relative to a passive strategy especially during a period of rising bond yields.

Exhibit 8
Risk Scenarios Expected Returns
Source: Western Asset. The scenario analysis is based on assumptions for scenarios, yield and spread shifts developed by Western Asset's global portfolios investment team. The rankings are based on 12-month projections of performance for the Barclays Global Aggregate Bond Index (USD hedged) for the passive bond strategy. The ranking of returns relative to the passive bond strategy for active global bond and unconstrained strategies are estimates based on the guidelines and risk tolerances of each strategy and actual ranking of returns may deviate from these estimates
Exhibit 9
Summary Characteristics of Fixed-Income Strategies
Source: Western Asset

Summary and Conclusions

Investors in bond markets currently face unprecedented challenges from the low yield environment and the multiple sources of uncertainty facing global markets. Fortunately, investors have a range of actively managed or unconstrained global fixed-income strategies with which to navigate these challenges. Each strategy delivers a distinct mix of return, risk and correlation characteristics which will have opportunities and risks at different points in the interest rate and business cycle.

To ensure the right mix of strategies, investors need to consider carefully their investment outlook and the chief risks they see to their base case. Moreover, investors need to evaluate the ranking of the factors that drive their allocation to the fixed-income asset class. The importance of features such as preservation of principal, income, scope for capital gains, risk tolerance, investment time horizon, liquidity and diversification to risk assets will also affect the appropriate mix of bond strategies. Finally, investors should carefully evaluate asset managers’ resources, process and track records in managing active and unconstrained fixed-income strategies.

Global Core Full Discretion (USD Hedged) Composite Performance Disclosure

Global Total Return Composite Performance Disclosure

  1. The alpha and beta attributions for traditional active bond and for unconstrained strategies are Western Asset’s estimates. They are based on multiple regressions of the returns of representative active global bond and unconstrained strategies against different market indices. These attributions may not reflect actual attributions in the future.
  2. Based on Western Asset’s Global Total Return strategy
  3. Based on Western Asset’s Global Core Full Discretion US dollar hedged strategy
  4. Based on Barclays Global Aggregate Bond Index (US dollar hedged)
  5. Based on Western Asset’s Global Core Full Discretion strategy
  6. Based on Western Asset’s Global Total Return strategy
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