Portfolio Construction Insights

A Fixed Income Balancing Act

Executive Summary

Financial professionals 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 financial professionals 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 financial professionals should focus on the basics and align their clients’ individual circumstances and objectives with the broader fixed income and equity environments. We can help.

A Larger Role for Fixed Income Plus Sectors...

In response to the 2008-2009 global financial crisis, the Federal Reserve slashed short-term interest rates and marked the beginning of a prolonged period of low economic growth and low interest rates in the U.S. Against a backdrop that weighed heavily on core fixed income investments, many investors searching for yield and performance moved into fixed income plus sectors, including high yield bonds, emerging markets debt, and floating rate bank loans.

Investment professionals followed a similar path and added exposure to higher-yielding plus sectors to generate income for their clients and to prepare their portfolios for the inevitable return of a rising-rate environment. As central banks reconcile monetary policy with global economic data, many financial professionals question how to position fixed income within their models. Our data suggests financial professionals’ portfolios, across the risk spectrum, are significantly exposed to plus sector assets.

...Can Affect Overall Portfolio Risk, Volatility, and Efficiency.

How does plus sector exposure affect your model portfolios? Our team of Portfolio Construction Specialists looked at 15 years of data for a series of five representative portfolios with varying allocations to equities, core fixed income, and plus sectors. The data suggest that increased exposure to plus sectors increased the portfolios’ volatility risk, particularly in more conservative models geared toward capital preservation. For example, we looked at a portfolio consisting of 40% equities and 60% fixed income, with half of the fixed income sleeve devoted to core and half to plus sectors. Our analysis shows that this relatively conservative 40/60 mix actually behaves more like a portfolio with a 49/51 mix of equities to fixed income in terms of portfolio volatility. Although less pronounced, we also found a significant impact in more aggressive, higher-equity portfolios intended for capital appreciation.

Fixed Income Allocations for Five Representative Models

As of 12/31/19

Fixed Income Allocations for Five Representative Models

Source: T. Rowe Price USI proprietary Client Investment Platform (CIP) database. Clients include broker-dealers, bank trusts, financial professionals, and RIAs.

Fixed Income Plus Categories: High yield bond, bank loan, world bond, emerging markets bond, emerging markets localcurrency, multi-sector, nontraditional bond, preferred stock, and convertibles.
Core Bond Categories: Intermediate bond, long-term bond, short-term bond, world bond USD-hedged.

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 financial professionals: 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?

Financial professionals 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, financial professionals 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 Financial Professionals Consider?

We believe a risk-aware approach that balances exposure to plus sectors, core fixed income, and equities can help financial professionals 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 financial professionals’ 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, financial professionals 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.

Portfolio Considerations
Portfolio Considerations

The image is for illustrative purposes only. Investment outcomes are not guaranteed. Results will vary.

Important Information

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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.

This material 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. 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 noted on the material 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.

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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