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Portfolio Construction Insights
Fixed Income: What To Do Now?
June 08 2021Fixed income investors should consider a broader, more flexible approach to address the current market environment.
Key Insights
- In the current fixed income environment, nominal interest rates remain low and credit valuations are elevated, but a positive economic outlook supports credit sectors.
- Market conditions have weighed on traditional fixed income ballast segments, such as long-term government, intermediate-term core, and core plus.
- Financial professionals added to intermediate-term segments over the past three years and reduced short-term and plus sectors, moves that increased duration – a common measure of interest rate sensitivity – in a low interest rate environment.
- Investors should evaluate their current fixed income allocations and strike a balance between interest rate risk, current yield, and credit risk.
Is the bond bull market over?
During a roughly 40-year bull market for bonds, yields on 10-year U.S. Treasuries fell from 15.84% in September 1981 to a low of 0.51% on August 5, 2020. Yields rebounded from their 2020 lows and reached 1.74% at the end of March 2021. As shown in Figure 1, total returns for many traditional ballast areas within fixed income were in negative territory over the eight-month peakto- trough period, including long-term government debt, intermediate-term core, and core plus.
To summarize the current fixed income environment, nominal interest rates remain low despite a recent spike and credit valuations are elevated. However, we believe a robust economic outlook should be positive for credit-oriented fixed income, and rising inflation expectations are likely to play a key role going forward.
In a recent paper “Leveraging a Diversity of Perspectives on Rising Rates,” Head of Investments and Group Chief Investment Officer Rob Sharps highlights the diverse views of our firm’s investment professionals on the direction of interest rates and resulting investment implications. Mr. Sharps believes that diversity of thought benefits our investors, stating “this range of perspectives can help portfolio managers evaluate the potential for scenarios that may not exactly align with their own outlook.”
Against this backdrop, we focus on how financial professionals have positioned their fixed income allocations and provide portfolio construction ideas to consider for a challenging fixed income environment.
Current conditions are weighing on traditional fixed income ballast sectors
(Fig. 1) Morningstar Fixed Income Category Average Total Return: August 5, 2020, through March 31, 2021
Past performance is not a reliable indicator of future performance. Category average performance is for illustrative purposes only and is not representative of any specific investment product.
Source: Morningstar Direct.
How are your peers currently positioned?
Financial professionals typically look for their fixed income allocations to provide portfolio ballast or relative stability, particularly when equity markets are volatile. As shown in Figure 2, they increased ballast over the past three years by adding to intermediate-term areas while reducing short-term and plus sector allocations. In a low interest rate environment, these moves increased portfolio duration, a common measure of interest rate sensitivity.
Financial professionals added to intermediate-term sectors while reducing short-term and plus sectors
(Fig. 2) Fixed Income Sector Allocations, 2018 Through 2020
Sources: T. Rowe Price Client Investment Platform (CIP) database and Morningstar Direct.
Based on allocations to underlying funds for Moderate Risk models. Duration calculated as of each year’s end.
What could financial professionals do now?
Figure 3 depicts the relationship between the effective duration of key fixed income sectors and their total return during the latest spike in interest rates, while the size of the bubbles indicates the SEC yield at March 31, 2021. Most sectors with a duration above five years saw negative results. To lower overall portfolio duration, investors should look to add to strategies from the left-hand side of the chart and/or increase allocations to strategies with large bubble sizes.
When constructing our own fixed income portfolios, T. Rowe Price believes in broad diversification across geography and sectors to gain exposure to multiple income sources, interest rate cycles, duration, and credit profiles.
Traditional ballast sectors underperformed as interest rates rose
(Fig. 3) Morningstar Fixed Income Category Total Return, Duration, and SEC Yield*
Past performance is not a reliable indicator of future performance. Category average performance is for illustrative purposes only and is not representative of any specific investment product.
Sources: Morningstar Direct. Analysis by T. Rowe Price.
* Total return is measured from August 5, 2020, through March 31, 2021. Effective duration and SEC yield are measured as of March 31, 2021.
In our discussions, we’re helping financial professionals prepare for two
primary scenarios:
Scenario #1
Position for continued rising yields and a steepening yield curve as intermediate and long-term rates rise and the Federal Reserve keeps short-term rates low.
1. Lower interest rate risk by reducing duration
- Expand shorter duration exposure by adding ultra-short, short-term, or nontraditional debt with low duration, funded through reductions in longterm, core, or core-plus positions.
- Increase higher yielding allocations by adding dedicated high-yield, bank loan, or emerging markets debt.
2. Revisit portfolio ballast
- Move longer-duration core and coreplus positions into select nontraditional bond strategies with higher yields and lower duration, focusing on those that could mitigate equity market volatility.
3. Use broad multi-sector mandates
- Increase and diversify credit exposure in a single multi-sector strategy.
Scenario #2
Position for a pause in rising rates, with lower interest rate volatility after a large spike upward. Based on current average positioning of financial professionals’ model portfolios, we see a tilt toward higher duration through allocations to intermediate-term sector.
1. Manage the trade-off between interest rate risk and credit risk
- Lower interest rate risk by selectively adding to higher-yielding areas such as high yield, bank loans, and/or emerging markets.
2. Use broad multi-sector mandates
- Allow the portfolio manager to make timely allocation decisions.
Portfolio Construction Solutions from
T. Rowe Price
If you’re looking to reposition your fixed income portfolios, we can help. Used independently or in combination, each component of our integrated suite of Portfolio Construction Solutions provides access to T. Rowe Price’s multi-asset expertise and global investment resources to address your portfolio
construction needs.
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Additional Disclosures
©2021 Morningstar, Inc. All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.
Important Information
Core vs Core 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 core 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.
Risks: Fixed income securities are subject to credit risk, inflation risk, 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. Investments in bank loans may at times become difficult to value and highly illiquid; they are subject to credit risk such as nonpayment of principal or interest, and risks of bankruptcy and insolvency. Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.
International investments can be riskier than U.S. investments due to the adverse effects of currency exchange rates and differences in market structure and liquidity, as well as specific country, regional, and economic developments. These risks are generally greater for investments in emerging markets.
Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only.
This material is provided for general and educational purposes only and is not intended to provide legal, tax, or investment advice. This material does not provide recommendations concerning investments, investment strategies, or account types; it is not individualized to the needs of any specific investor and not intended to suggest any particular investment action is appropriate for you, nor is it intended to serve as the primary basis for investment decision-making. 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.
The views contained herein are those of authors as of May 2021 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
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