Financial advisors increased their allocations to fixed income plus sector assets in recent years as they searched for yield and prepared for the impact of rising U.S. interest rates. Our analysis suggests that advisors may not be aware of the full extent of their plus sector exposure and the unintended risks that it could introduce to their client portfolios. As they try to balance competing priorities, we believe advisors should focus on the basics and align their clients’ individual circumstances and objectives with the broader fixed income and equity environments. We can help.
Fixed Income Allocations for Five Representative Models
As of 3/31/19
Source: T. Rowe Price USI proprietary Client Investment Platform (CIP) database. Clients include broker-dealers, bank trusts, financial advisors, and RIAs.
Fixed Income Plus Categories: High Yield Bond, Bank Loan, World Bond, Emerging Markets Dollar-Denominated Bond, Emerging Markets Nondollar Bond, Multi-sector, Nontraditional Bond, Preferred Stock & Convertibles Core Bond Categories: Intermediate Bond, Long-Term Bond, Short-Term Bond
In essence, increased allocations to plus sector assets in model portfolios swapped interest rate risk for volatility risk more typical of equities. The bottom line for advisors: your portfolio strategy may not be aligned with reality.
While plus sector assets could result in an unintended—and often undesirable—increase in equity-type risks in more conservative portfolios, they can maximize portfolio efficiency (the highest total return for a given level of risk) in more aggressive models. For example, a portfolio with a 60/40 mix of equities to bonds with plus sectors accounting for half of its fixed income component was more efficient than an 70/30 portfolio with only core fixed income exposure.
Whither Interest Rates and Equity Markets?
Advisors often increased their plus sector exposure to minimize the impact on returns from a rising rate environment. In previous periods when intermediate- and long-term interest rates were rising, our analysis shows that plus sector assets increased the return potential of fixed income portfolios. This is in addition to their long-established yield advantage over more traditional core fixed income.
However, advisors must be aware of the other ways that plus sector assets can transform the broader risk profile of their client portfolios. For instance, plus sector performance is highly correlated to equities, with obvious implications for the perception of stability and safety traditionally associated with fixed income assets. Additionally, diversification into emerging markets bonds, for example, adds a host of political, economic, and currency risks not typically shared by core fixed income.
Plus sector exposure could carry opportunity costs, as well. Plus sectors trailed stock returns in prior equity bull markets and offered less downside mitigation potential than core fixed income during equity bear markets. While plus sectors can outperform core in a rising rate environment, they tend to underperform when rates are falling—a key consideration should circumstances force the Fed to reverse course on its current interest rate policy.
What Should Advisors Consider?
We believe a risk-aware approach that balances exposure to plus sectors, core fixed income, and equities can help advisors keep their portfolios aligned with the individual needs and objectives of their clients. As a general rule, T. Rowe Price’s research suggests that 70% of total fixed income exposure in advisors’ models be dedicated to core assets as a counterweight to the models’ equity exposures in order to minimize portfolio risk and maximize risk-adjusted returns. The remaining 30% may be allocated to a mix of strategies, including plus sectors, to be adjusted dynamically depending on a model’s equity exposure. In lower equity models, advisors could diversify duration risk through a mix of plus sector strategies. In higher equity models, duration could help diversify or counterbalance pure equity risk.
Acknowledging that managing these considerations can be art as much as science, we can help. Contact your T. Rowe Price representative, and our Portfolio Construction Specialists will perform an in-depth analysis of your portfolios to help you ensure they maximize your clients’ opportunities for financial success.
The image is for illustrative purposes only. Investment outcomes are not guaranteed. Results will vary.
Core vs Plus Fixed Income: Core and Plus are terms used in the investments industry to describe two types of fixed income investment strategies. Core generally refers to fixed income investment strategies that focus on investment grade corporate and government bonds. A Plus strategy adds additional fixed income sectors like high-yield bonds, emerging market bonds, and floating rate bank loans in an attempt to improve income or return potential in exchange for a higher risk profile.
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Risks: Investing involves risk including loss of principal. Diversification neither assures a profit nor eliminates the risk of experiencing investment losses. Fixed income securities are subject to credit risk, inflation, liquidity risk, call risk, and interest rate risk. As interest rates rise, bond prices generally fall. Investments in high yield (junk) bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. Bank loans are subject to credit risk and liquidity risk. Emerging market investments can be riskier than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as specific country, regional, and economic developments.
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