KEY TAKEAWAYS

  • Western Asset has been managing unconstrained portfolios since 2004.
  • As an unconstrained strategy, TRU is not limited by traditional benchmarks and is very flexible in terms of its duration and sector exposures.
  • The strategy’s duration can range from -3 years to +8 years, which is a key tool to help position the strategy for a variety of market environments.
  • Western Asset is distinguished by our global footprint, depth of resources and long history in actively managing fixed-income investment strategies.

We find ourselves in an interesting economic environment in early 2021, especially for fixed-income investors. Yields on government bonds in the US and abroad are near all-time lows. Spreads on many sectors appear close to what could be called fair value. Measures of actual inflation remain low, but forward-looking market measures of inflation have been moving higher, perhaps in anticipation of economies picking up steam as they reopen (aka “reflation” or the “reopening trade”). Reasonable arguments can be made that growth will muddle along at a subdued pace in the year ahead or that it will quickly accelerate. It is precisely in uncertain environments such as now when investors may benefit from the flexibility inherent with unconstrained strategies such as TRU.

Given the amount of slack present in the economy and the continued disruption in labor markets due to ongoing COVID-19 concerns, Western Asset is currently not anticipating a meaningful increase in inflation, at least in the near term. However, we remain cognizant of factors that could change our expectations. Chief among these would be the successful implementation of effective vaccines that cause the Covid threat to diminish at a quicker pace than currently expected. This in turn could cause the reopening of economies to accelerate, leading to higher growth and reduced economic slack. Combine this scenario with continued highly accommodative monetary policy and perhaps even increased fiscal stimulus and we could envision a scenario of higher inflation and higher interest rates.

Investors are currently focused on the threat of higher inflation and interest rates as US Treasury (UST) rates have indeed moved higher year to date and the yield curve has steepened. The topic is at the forefront of our clients’ minds as it has come up many times during conversations this year.

There are two sides to every coin, however. Investors often fixate on just one of them. In this instance, we see a pronounced focus on the rising interest rate environment but a disregard for the other side of the issue, the causal forces that lead to higher interest rates and inflation. Interest rates do not increase in a vacuum, and the key point is that not all rising interest rate scenarios are bad ones; in fact, they sometimes can represent a side effect of a very healthy, improving economy.

The market’s inflation worries hinge on the timing of the reopening trade, given that successful vaccination campaigns could result in the economy growing more quickly than anticipated as the Covid threat diminishes. When restaurants reopen, people start traveling again for both work and pleasure, and hotels begin to fill up again on a large scale, growth could skyrocket. This is a very constructive scenario for risk assets and for fixed-income spread product. This is what we believe many investors tend to ignore. Most investors will gladly accept a degree of higher interest rates and inflation if it is accompanied by a healthy economy that is lifting all boats.

This is the type of market environment in which TRU may help investors. Think of TRU as a double-barreled solution. First, with its duration flexibility of -3 to +8 years, TRU has the ability to mitigate the brunt of challenges investors experience in a rising rate scenario. Second, with its sector flexibility and freedom from the arbitrary constraints imposed by benchmarks, TRU can place emphasis on the sectors that are most likely to experience spread compression as the global economy gains strength. Thus, TRU can address both sides of the coin in what would be the most likely scenario of rising interest rates in the coming months.

TRU Duration Flexibility

Looking first at TRU’s duration flexibility, what has it meant for investors in environments when rates have been increasing relative to a broad market proxy? To answer this question, we first identified all months going back to July 2004 when the yield on USTs, as measured by the yield on the Bloomberg Barclays US Treasury Index, increased by 15 basis points (bps) or more. We then calculated both the average return and the cumulative return for both TRU and the Bloomberg Barclays Aggregate (BBAGG) Index for the 31 months that matched our criteria. The results are depicted in Exhibit 1.

Exhibit 1: Performance of TRU vs. Aggregate Index in Rising-Rate Environments
Explore Performance of TRU vs. Aggregate Index in Rising-Rate Environments.
Source: Bloomberg Barclays, Western Asset. As of 28 Feb 21. Select the image to expand the view.
Past performance is not indicative of future results. Please see the Performance and Risk Disclosure for more information.

It should not be surprising that TRU, with its lower duration profile and much greater duration flexibility, outperformed the Aggregate Index in periods when rates were rising.

While the future is uncertain, TRU has the ability to dynamically respond to changing market conditions as shown in Exhibit 2, which illustrates TRU’s duration positioning over the last five years along with the duration of the BBAGG Index.

Exhibit 2: Historical Duration—TRU vs. Bloomberg Barclays Aggregate Index
Explore Historical Duration—TRU vs. Bloomberg Barclays Aggregate Index.
Source: Bloomberg Barclays, Western Asset. As of 28 Feb 21. Select the image to expand the view.

TRU has used its ability to hold negative duration on multiple occasions and has also extended its duration out as far as about +5.5 years. TRU’s average duration has been about +2.2 years, much lower than that of the BBAGG Index, which has averaged about 6 years. For benchmarked strategies that allow only a +/- 25% leeway from the Index duration, this would result in roughly a 4.5- to 7.5-year duration range.

TRU Sector Flexibility

TRU’s sector flexibility allows the portfolio managers to exploit opportunities in those sectors that stand to benefit from the US and global recovery story; Exhibit 3 features TRU’s sector allocation as of January 31, 2021.

Exhibit 3: TRU Sector Exposure
Explore TRU Sector Exposure.
Source: Western Asset. As of 28 Feb 21. Select the image to expand the view.

As the allocations In Exhibit 3 demonstrate, we see meaningful opportunity in certain spread sectors, namely high-yield credit, bank loans and emerging markets (EM)—particularly in local currency denominated debt. For now, these are the sectors within the TRU strategy where we have placed emphasis, because we feel they are poised to benefit as economic recovery gains strength both at home and abroad. TRU also has the flexibility to allocate more emphasis on these sectors relative to benchmarked portfolios. Furthermore, TRU can de-emphasize the sectors where we see little opportunity, such as agency MBS. For a detailed look at Western Asset’s outlook for specific sectors, please see our latest Global Outlook and for our insights on the credit markets by sector and see our Global Credit Monitor.

While Western Asset’s outlook is not calling for sharply rising interest rates and inflation in the short term, we are well aware of the forces that could give rise to them, and we remain diligent. The recent increase in interest rates may yet be sustained or interest rates could move sideways. Regardless, we believe that the global economy will continue to strengthen as the Covid threat slowly fades—the main question, though, is how quickly this will transpire. TRU has the unique ability to buffer investors from a direct hit due to rising rates while participating in the spread compression across credit markets that typically accompanies periods of sustained growth.

View the Performance and Risk Disclosures for Total Return Unconstrained.