In our view, combining an unconstrained strategy with high-quality, government-backed GNMA bonds is an effective way for advisors to protect client portfolios and take advantage of current yield opportunities.
- Unconstrained strategies have greater flexibility to identify attractive yield opportunities and manage interest rate risk.
- GNMA bonds help diversify credit risk and can serve as an anchor during broader equity market selloffs.
- Used together, GNMA bonds and unconstrained fixed income can be an effective complement to core fixed income allocations, allowing investors to capitalize on the current opportunity while remaining mindful of broader market risks.
The Agg is no longer a one-stop shop for bond allocations
Following the recent market turbulence, many advisors are rethinking core bond allocations. While philosophies about fixed income allocations vary, most advisors agree that the Agg alone doesn’t fully meet the needs of most investors. Bonds need to protect portfolios on multiple fronts. Adding flexibility can significantly enhance the risk profile of a fixed income portfolio.
For example, complementing Agg-based strategies with an unconstrained allocation can help advisors capitalize on the current pickup in yields across fixed income, and add a layer of protection if rates continue to move higher. On the other side of the spectrum, incorporating a standalone allocation to high-quality GNMA bonds helps diversify credit risk and can serve as an anchor during broader equity market selloffs.
Unconstrained fixed income: Going where the opportunities are
Because unconstrained fixed income strategies aren’t bound by a benchmark, they have greater flexibility to identify attractive yield opportunities and manage interest rate risk. They can adjust allocations dynamically across corporate credit, securitized debt, emerging markets and other global bond sectors. They can also dial a portfolio’s duration up or down based on the manager’s market outlook for interest rates. This freedom to invest anywhere may be especially important at inflections in the market cycle due to differences in sector sensitivities and changes in rate expectations.
While manager selection is always important, we believe it’s crucial within unconstrained approaches given the greater discretion that managers have. It’s not uncommon to see a 1000-basis-point difference in performance between the 5th and 95th percentile managers in the nontraditional bond category.
In our view, an unconstrained strategy should focus on risk-adjusted returns and demonstrate lower correlation to rates and equities over the long term.
GNMA: High-quality bonds with a government guarantee
GNMA bonds are privately issued residential mortgage-backed securities guaranteed by a government agency called the Government National Mortgage Association (also known as “Ginnie Mae”). Other than Treasuries, GNMA bonds are the only security explicitly backed by the full faith and credit of the United States government. That means when a mortgage borrower defaults on their loan, the government steps in to guarantee the loan’s full value to investors.
Because of the government guarantee, GNMA bonds have historically performed well during economic downturns. For example, from 1990 to 2021, GNMA bonds achieved positive returns every year that equities were negative, including sizeable gains during the 2008 financial crisis and Covid-19 dislocation.1 Few “low-risk” bond sectors, even among short-term bond strategies, have historically delivered this type of protection.
GNMA bonds are coming off an uncharacteristic period, with mortgage rates going from all-time lows in mid-2021 to the highest in a decade in mid-2022. The velocity of interest rate hikes has hurt the sector’s performance in 2022, but current prices for GNMA bonds reflect the extreme nature of this move, setting up a potentially compelling entry point for investors.
Implementing a credit barbell: Framework for a strategic allocation
To help advisors assess the efficacy of GNMA and unconstrained strategies in a broader portfolio, we conducted historical analysis that replaces a 100% passive allocation to the Agg with differently sized allocations to the following three Voya funds:2
1. Core – Voya Intermediate Bond Fund (IICIX)
2. Unconstrained – Voya Strategic Income Opportunities Fund (IISIX)
3. GNMA – Voya GNMA Income Fund (LEINX)
Our historical analysis, shown below covering 10 years of common data, demonstrates that with each adjustment in allocation:
- Volatility decreased
- The Sharpe ratio improved
As of 11/30/22. Source: Voya Investment Management and Morningstar. The performance quoted represents past performance and does not guarantee future results. Current performance may be lower or higher than the performance information shown. The investment return and principal value of an investment in the Portfolio will fluctuate, so that your shares, when redeemed, may be worth more or less than their original cost. Returns for the other share classes will vary due to different charges and expenses. Performance assumes reinvestment of distributions and does not account for taxes.
The opportunity cost of idle cash
A key reason to own fixed income is to diversify equity and credit risk. That assumption hasn’t held up well in 2022, but episodes of simultaneous drawdowns between rates and equities are typically brief. With the Fed indicating that more rate hikes are on the way, many advisors are choosing to hold more cash and short-term strategies, reducing allocations to core bonds — or worse, holding no exposure to core bonds at all. In our view, there are several reasons why this positioning is a mistake:
- Additional rate hikes are already priced in: The direction of the 10-year Treasury and other term rates is largely out of the Fed’s direct control. Instead, rates are determined by market expectations for growth, inflation and future policy decisions.
- Expect bonds to act like bonds: If a recession became more likely, bonds would probably rally as investors flocked to relatively safer assets.
- Yields have reset higher, meaning more income for less risk: Treasuries yielded 1.23% at the beginning of 2022 — as of November 30, 2022, the yield is 4.05%, which means the opportunity cost of not owning fixed income has grown.7
We believe a combination of unconstrained fixed income and GNMA bonds can be an effective complement to core fixed income allocations, allowing investors to capitalize on the current opportunity while remaining mindful of broader market risks.
To learn more about these strategies, and about the ways Voya can help advisors meet their clients’ fixed income needs, contact your Voya IM representative.