Top
Over the last several years, credit spreads across a variety of fixed income sectors have tightened dramatically and are now trading near their most expensive valuations in years. For example, investment grade corporates, fueled by strong demand from absolute yield buyers, are now trading at their tightest spreads in nearly 30 years. Given the fact that the Bloomberg U.S. Aggregate Bond Index (“the Agg”) is predominantly comprised of Treasurys and investment grade (IG) corporate bonds, and considering the possibility of a limited amount of spread compression on the horizon at today’s valuations, investing in the Agg for more than coupon income seems akin to just betting on falling rates.
Looking beyond the Agg for yield, return & diversification1 potential
There may be a better option, and investors may benefit by looking beyond traditional core fixed income sectors and consider investing in the “plus sectors” of the global fixed income markets. Attractive opportunities may be found in sectors such as emerging markets (EM) debt, agency and non-agency residential mortgage-backed securities (RMBS) and high yield corporates, for example, which have historically offered attractive yields, competitive returns and diversification versus core fixed income markets with different levels of risk.
Yield-Worst: Agg Sectors vs. "Plus Sectors"
Yield-Worst: Agg Sectors vs. "Plus Sectors"
The challenge for many investors, however, is determining when and how much to invest in these "plus sectors", as it can be difficult to determine the appropriate time to increase EM debt exposure or to reduce floating-rate loan exposure, for example. To be sure, the average investor has generally mis-timed these allocation decisions, resulting in inferior investor returns compared to the category averages.
Total Return vs. Investor Return
Total Return vs. Investor Return
Top-down and bottom-up
Knowing when and how much to allocate to various fixed income sectors can be extremely important to achieving the best potential total returns. Equally important is the ability to identify attractive opportunities within each sector. For example, there are over 100 different EM countries with investable assets, representing a more than $15 trillion opportunity set3, and each has a unique political, fiscal and monetary policy path, as can be seen in the performance difference across various countries in the EM index. We believe that having a well-resourced, experienced team to identify country-specific alpha opportunities can add a substantial amount of value versus a passive approach.
The same discernment and resources should guide investing in other sectors, such as high yield corporates and mortgage-backed securities (MBS). Take agency MBS, for example. While performance on the Bloomberg U.S. Mortgage Backed Securities Index posted a 1.2% gain last year, examining performance across the MBS coupon stack exposes a wide performance dispersion. Returns spanned a nearly 630 basis point (bps) range, with higher coupon bonds generating strong positive total returns while the lowest coupon bonds underperformed. These cases clearly demonstrate how adding value from bottom-up security selection may augment the flexibility of allocating across sectors, creating a powerful combination.
Performance by Asset Class: EM vs. RMBS
Performance by Asset Class: EM vs. RMBS
Bottom Line: A flexible, diversified portfolio of “plus sector” fixed income exposures may benefit investors by actively adding value via both macro-driven, top-down, sector allocation and bottom-up, fundamental security selection.
Featured Insights
This image indicates content designed specifically for Financial Advisors / Investment Professionals. This material is not to be used with the public.