Fixed Income  

How to advise on unconstrained fixed income

  • Understand the global macroeconomic factors affecting fixed income markets.
  • Learn how to allocate to unconstrained fixed income.
  • Grasp what the attributes are of unconstrained fixed income products.
How to advise on unconstrained fixed income

Uncertainties caused by Brexit, Donald Trump’s presidency and the resignation of Italy’s prime minister Matteo Renzi mean global bond markets remain volatile.

This year, they are likely to be driven as much by political uncertainty as by economics.

Against this backdrop, it is likely investors will continue to value high-quality, sovereign and investment grade bonds for their liquidity and perceived risk-free return.

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The trend of steadily declining bond yields since the 2008 financial crisis may be showing some signs of reversing, but the outlook for global monetary policy has become increasingly unclear.  An increase in US interest rates at this month’s Federal Reserve meeting is widely anticipated while there is the possibility of the European Central Bank and the Bank of Japan acting to normalise monetary policy more quickly than previously believed.

Traditionally, a fixed-income allocation provides the benefits of diversification in a broader portfolio, while offering the potential for excess returns.

Many fixed income portfolios, particularly in insurers’ and pension plans, allocate to traditional, core-bond strategies to provide a stable source of capital to meet future liabilities and to protect the portfolio in periods of higher volatility. Since a flight to quality is common during periods of high volatility, these assets will normally appreciate when higher risk assets, such as equities, are falling.

Investors are challenged with a complicated financial landscape, with bond yields at or close to historic lows and interest rate risk high while return expectations have fallen.

Broad opportunity set

This environment has left investors struggling to meet inflation-adjusted return targets, while simultaneously hedging their fixed-income allocations from the effect of rising rates. This has prompted fund groups to launch a wide variety of unconstrained, fixed-income products that can enable managers to take full advantage of a broad opportunity set and a wider array of rate and credit instruments.  

In an unconstrained portfolio, the lack of a traditional benchmark removes the need to maintain exposure to duration, or any other combination of fixed-income risk factors such as currency risk, economic growth risk, liquidity risk, or issuer specific risk.

Unconstrained fixed-income approaches generally target returns relative to a cash benchmark such as 3-month Libor (with a duration of about 0.25 years) which has the effect of reducing the measure for duration risk to zero.

This approach can also allow the manager to potentially generate positive returns from rising rates by moving to a negative duration position.

The eVestment global unconstrained fixed-income universe has grown from around $92bn in 2009 to close to $500bn by the end of 2015, invested across 125 different manager products. 

How to incorporate into portfolios

To date the performance of many unconstrained fixed income products has been mixed, benefiting initially from an environment of stable credit spreads and declining interest rates during 2009-13 but have then struggled since the anticipated rise in interest rates has taken far longer than expected to materialise.