Price Point - In Brief

Multi-Asset Investing

The Impact of Yield Constraints on Portfolio Optimization

Averie Thomas, Solutions Analyst
Justin Harvey, CFA, ASA, Solutions Strategist for Multi-Asset Solutions

Executive Summary

  • Global demographic trends have caused retirement plan sponsors and investment managers to think more about portfolio construction with specific income and yield objectives in mind.
  • Our analysis examines the impact of single and layered constraints on an efficient frontier composed of multi-asset portfolios, with a focus on strategies involving a targeted yield.
  • Given a set of assumptions, we found that adding multiple conflicting constraints, such as imposing both a yield minimum and a credit quality minimum, had the greatest impact on the efficient frontier and could lead to portfolios with lower Sharpe ratios.
  • Using optimization as one input to a portfolio construction process is a common practice. However, investors often settle for portfolios that are below an efficient frontier due to constraints that are imposed by themselves (e.g., a home-country bias) or by a regulatory body (e.g., a maximum allocation to “risky” assets) or that are consistent with prevailing portfolio theory (e.g., a diversification requirement).

For this analysis, we calculated efficient frontiers with different combinations of yield constraints to examine the effects they could have on the resulting portfolios, including their expected risk and return characteristics and expected yields. We focused on yield target constraints, alone and in combination with a cap on exposure to fixed income assets rated below investment grade (IG). The specific efficient frontiers calculated were based on:

  1. an unconstrained portfolio,
  2. an imposed 4% yield target,
  3. an imposed 5% yield target, and
  4. an imposed 4% yield target combined with a 30% cap on exposure to
    below- IG fixed income assets.


While the results of any efficient frontier analysis will depend heavily on the asset classes included and the return, volatility, and correlation assumptions used, Figure 1 clearly shows that imposing single and multi-layered yield constraints can significantly alter the shape of an efficient frontier. The 4% yield target frontier and the 5% yield target frontier both follow the unconstrained frontier until they are forced into staggered parallel dips. The layered frontier never follows the unconstrained frontier; at lower levels of volatility, it is actively constrained by the below-IG cap, and at volatility levels greater than 8.5% it is limited by the 4% yield target.

Figure 1: Efficient Frontiers for Unconstrained and Yield-Constrained Multi-asset Portfolios

Source: T. Rowe Price.
See appendix for important information regarding this analysis.

When a constraint becomes “active,” the asset allocation in the resulting portfolio can change, potentially drawing in asset classes that were not included in the unconstrained allocations. Figure 2 summarizes the impact that different constraints may have on expected returns, Sharpe ratios, and portfolio concentrations at different volatility tolerances.

Figure 2: Key Portfolio Metrics

Source: T. Rowe Price.
See appendix for methodology and assumptions.

With an 8.5% volatility tolerance, the frontier for a 5% yield target is forced to underweight global equities and overweight real estate compared with an unconstrained frontier. Similarly, for volatility tolerances of less than 8.5%, the layered constraint frontier is forced to underweight global high yield and overweight real estate, global aggregate bonds, and emerging market (EM) bonds.

These constraints not only affect allocations and concentrations, they can also impact expected returns and Sharpe ratios. For example, with a 10% volatility tolerance, the addition of either of the yield target constraints reduces the expected Sharpe ratio. In some instances, constraints significantly limit the range of the efficient frontier; Figures 1 and 2 both show that the 5% yield target frontier does not extend to volatilities greater than 9%.


Portfolios designed to deliver specified levels of yield and natural income have become increasingly common as population trends in the developed markets have brought asset decumulation into focus. However, focusing on optimizing portfolios with specific income considerations can change the shape of an efficient frontier.

Ultimately, imposing a yield minimum may lead to portfolios with lower Sharpe ratios. It also could result in allocations with very different concentrations.

Imposing multiple constraints that are difficult to achieve (such as an aggressive yield target combined with a cap on below-IG exposure) potentially has the largest impact on portfolio risk/return characteristics and Sharpe ratios.


All efficient frontiers are based on an underlying set of capital market assumptions (CMAs). While the analysis is based on a single set of CMAs, the results are generalizable to any set of assumptions. These generalized CMAs correspond to the expected risk, return, and yield characteristics of different asset classes. Cash was not included as an asset in the portfolios but was used to compute Sharpe ratios.

Figure A1: 10-Year Generalized Capital Market Assumptions

As of June 30, 2018

Source: T. Rowe Price.

Figure A2: 10-Year Correlation Assumptions

As of June 30, 2018

Source: T. Rowe Price.

IMPORTANT: The projections or other information generated by our analysis regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. The projections are based on assumptions and are illustrative in nature. There can be no assurance that the projected results will be achieved or sustained. The results do not reflect the impact that material economic, market or other factors may have on weighting decisions. If the weightings change, results would be different. Management fees, transaction costs, taxes, and potential expenses are not considered and would reduce returns.

The charts and tables present only a range of possible outcomes. Actual results will vary with each use and over time, and such results may be better or worse than the projected scenarios. Clients should be aware that the potential for loss (or gain) may be greater than demonstrated in the projections.

The results are not predictions, but they should be viewed as reasonable estimates. Source: T. Rowe Price Associates, Inc.

Key Risks—The following risks are materially relevant to the information highlighted in this material:

Even if the asset allocation is exposed to different asset classes in order to diversify the risks, a part of these assets is exposed to specific key risks.

Equity risk—in general, equities involve higher risks than bonds or money market instruments.

Credit risk—a bond or money market security could lose value if the issuer’s financial health deteriorates.

Emerging markets risk—emerging markets are less established than developed markets and therefore involve higher risks.

Real estate investments risk—real estate and related investments can be hurt by any factor that makes an area or individual property less valuable.


Important Information


This material is being furnished for general informational purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, and prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request. 

It is not intended for distribution to retail investors in any jurisdiction.

USA—Issued in the USA by T. Rowe Price Associates, Inc., 100 East Pratt Street, Baltimore, MD, 21202, which is regulated by the U.S. Securities and Exchange Commission. For Institutional Investors only.

© 2018 T. Rowe Price. All rights reserved. T. ROWE PRICE, INVEST WITH CONFIDENCE, and the Bighorn Sheep design are, collectively and/or apart, trademarks of T. Rowe Price Group, Inc.




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