Unconstrained Fixed Income

How does it fit in broader portfolios?

Executive Summary

  • Our research provides a framework for investors looking to include unconstrained fixed income as part of a strategic fixed income allocation
  • We believe blending 30% (unconstrained) with 70% (core/core plus) can serve as a starting point that may add consistency and reduce volatility
  • Unconstrained is a compelling alternative, and as the chart below shows, manager selection in this space is critical

Complementing traditional fixed income with Nontraditional improved risk, while choosing a top quartile manager improved risk AND returns

Figure 1. Nontraditional Bonds: Compelling at Category Level, More So With Top Quartile Managers
Figure 1. Nontraditional Bonds: Compelling at Category Level, More So With Top Quartile Managers

Source: Morningstar Direct, Bloomberg Barclays and Voya Investment Management.Nontraditional Bonds as represented by the Morningstar Nontraditional Bond Category. Aggregate as represented by the Bloomberg Barclays Aggregate Bond Index. Nontraditional Top Quartile Portfolio represented by an equal-weighted portfolio of Top Quartile ranked funds for the period Jan 2013 – Dec 2018, using Advisor, I-share, Institutional Share or cheapest share class if none of the previously listed were offered, rebalanced annually. Efficient frontiers as represented by blended portfolios using the Aggregate and Nontraditional Bonds (in grey) and the Aggregate and Nontraditional Top Quartile Portfolio (in orange) in 5% increments. Portfolios are re-balanced annually back to target weights at calendar year-end.

Voya’s Research Framework: Understanding How Unconstrained Can Complement Core Fixed Income

Unconstrained fixed income can play an important, complementary role in investors’ fixed income allocations. Indeed, with uncertainty in global markets continuing to mount, we feel the key question is not if investors should allocate to unconstrained, but how much?

To answer this question, we analyzed the performance of different allocations between the Bloomberg Barclays U.S. Aggregate Bond Index (the “Agg”) and the Morningstar Nontraditional Bond Fund category.

While Morningstar reports data for the Nontraditional category going back to 1996, the data for our analysis begins January 2013, when the category was more broadly adopted. This was also the year assets first crested $100 billion.

To help investors understand how to apply Unconstrained Fixed Income as a strategic allocation, we analyzed the Nontraditional universe through the lens of two objectives that we believe are essential to the role of bonds in investors’ portfolios:

  • Focus on risk-adjusted returns: Maximize Sharpe Ratio.
  • Bonds should act like bonds: Maintain rolling 12-month correlation >0.80 to the Aggregate and <0.50 to the S&P 500.

Objective #1: Maximize Sharpe Ratio

Since our framework assumes the investor requires their overall fixed income allocations to serve as the anchor in their portfolios, one of our primary goals in this analysis was to identify a blend of the Agg and Nontraditional that maximized risk-adjusted performance.

Using just Sharpe ratio, a 50/50 blend is a good starting point

Figure 2 shows the Sharpe Ratios for the various blends in 5% increments for the period January 2013 – June 2019. Blending the Agg and Nontraditional for the time period did indeed increase the portfolio’s Sharpe Ratio. In fact, an equal-weighted 50/50 split between the Agg and Nontraditional produced one of the highest Sharpe ratios over the period.

Figure 2. Blending the Agg and Nontraditional increased Sharpe ratio
Figure 2. Blending the Agg and Nontraditional increased Sharpe ratio

Source: Morningstar Direct, Bloomberg Barclays and Voya Investment Management Nontraditional as represented by the Morningstar Nontraditional Bond Category. Aggregate as represented by the Bloomberg Barclays Aggregate Bond Index Blended portfolios using the Aggregate and Nontraditional Bonds in 5% increments. Portfolios are re-balanced annually back to target weights at calender year-end.

Objective #2: Bonds should act like Bonds

Now, if maximizing Sharpe Ratio was our only goal, we could simply split the allocation down the middle and be done with it. However, effectively implementing Unconstrained requires a more nuanced approach. Although risk-adjusted performance is an important metric to consider, it does not tell the whole story. How an allocation performs in relation to other asset classes is equally crucial for investors seeking to diversify their portfolios. With this in mind, we firmly believe that even in the case of a diversified or enhanced fixed income allocation, bonds should act like bonds, which, in the context of our framework, can be achieved via two core attributes:

  • Allocations should maintain a minimum correlation of 0.8 to the traditional fixed income benchmark
  • Allocations should maintain a maximum correlation of 0.5 to the broad equity market index.

Rather than relying on a single correlation observation for the entire period, we reviewed the trailing 12-month correlations for the entire data set. We selected a 12-month period to align with the frequency of portfolio review meetings. In our view, maintaining these correlations best positions investors to consistently capture better risk-adjusted performance, while retaining key attributes required from a fixed income allocation.

To maintain traditional bond characteristics, a 70/30 blend is a better starting point

The dark blue line in Figure 3 plots the minimum trailing 12-month correlations observed versus the Aggregate and the maximum trailing 12-month correlations observed versus the S&P500. In both displays, our 50/50 portfolio fails on both of these tests. However, a 70/30 blend reveals a better starting point for blending the Agg with Nontraditional bond funds in order to achieve this correlation dynamic.

Figure 3. A Review of Correlations Raises the Bar and Lowers the Allocation
Figure 3. A Review of Correlations Raises the Bar and Lowers the Allocation
Figure 3. A Review of Correlations Raises the Bar and Lowers the Allocation

Source: Morningstar, Bloomberg Barclays and Voya Investment Management Aggregate as represented by the Bloomberg Barclays Aggregate Bond Index, Nontraditional as represented by the Morningstar Nontraditional Bond Fund Category and Multisector as represented by the Morningstar Multisector Bond Category. Each point represents the minimum trailing 12-month correlation to the Aggregate for each blended portfolio for the period Jan 2013-Jun 2019. Blended portfolios are re-balanced annually to target weights at calendar year-end.

Manager Selection: The Difference between a trade-off and a trade-up?

So far, our recommendation for a 70/30 blend has focused on category level construction. However, there’s a crucial dynamic that must be addressed: the importance of manager selection in the Nontraditional space. In “Unconstrained Bond Funds: Bad Idea or Good Idea Poorly Executed?” we highlighted the significant performance dispersion that occurs in the Nontraditional bond fund category. It is common to see a difference of nearly 1,000 basis points in manager performance when comparing the 5th and 95th percentile managers. While manager selection in all fund categories is important, we believe it is even more crucial within unconstrained approaches given the greater degree of discretion managers have.

An allocation to the Nontraditional category illustrates a typical risk-reward relationship, a nice reduction in volatility for a modest trade-off in performance. However, an allocation to a Top Quartile Nontraditional Bond offers an even more provocative risk-reward relationship, as the performance of an equal-weighted portfolio of top quartile managers for the period Jan 2013 through June 2019 highlights a superior risk and return profile compared to the nontraditional bond fund category and the Aggregate. Figure 4 summarizes key performance statistics for allocations to the general Nontraditional category as well as the Nontraditional Top Quartile portfolio.

Figure 4 also illustrates how the disparity between a top-quartile 70/30 construction and a simple category level one can affect a portfolio. The left most illustration in Figure 4 shows that both blends offer a reduction in portfolio volatility, yet there is a superior risk-reward profile for the top-quartile allocation, shown in orange. Meanwhile the right illustrations indicate better Sharpe ratios and improvement in max drawdowns for both blends. Per Figure 4, while the 70/30 blend does make sense at the category level, prudent manager selection can make a “trade-off” a “trade-up”.

Figure 4. Greater Return Dispersion Highlights Importance of Manager Selection
Figure 4. Greater Return Dispersion Highlights Importance of Manager Selection
Figure 4. Greater Return Dispersion Highlights Importance of Manager Selection

Source: Morningstar and Voya Investment Management Intermediate as defined by the Morningstar Intermediate-Term Bond Category Returns, Nontraditional as defined by Morningstar Nontraditional Bond Fund Category Returns and 50/50 Blend as defined by an equal-weighted portfolio of Intermediate-Term Bond and Nontraditional Bond Fund categories, re-balanced annually.

Approaches to Implementation

Using the 70/30 traditional/Nontraditional blend as a starting point, the final question becomes: How can investors implement this approach? Figure 5 highlights four high level profiles that can help when making this decision:

  • Risk Delegator: delegates sector decisions and risk allocation to investment management partners; we believe the Delegator would be comfortable allocating 70% to Core/Core Plus strategies and 30% to Nontraditional Bond Funds.
  • Risk Mitigator: generally comfortable risk-delegating and looks to diversify strategy risk. Nontraditional still makes sense; would want to introduce a second strategy by allocating equally between Nontraditional and Multisector.
  • Risk Allocator: wishes to express sector views in fixed income allocations; similar to the Risk Mitigator, find Nontraditional interesting and will pair with single sector funds, i.e. High Yield, Emerging Markets, Securitized Credit, etc.
  • Risk Indexer: fully passive on fixed income, i.e. using an Aggregate ETF or other passive vehicle
Figure 5. Unconstrained Can Fit Into Various Allocation
Figure 5. Unconstrained Can Fit Into Various Allocation
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Investment Risks

All investments in bonds are subject to market risks. Bonds have fixed principal and return if held to maturity, but may fluctuate in the interim. Generally, when interest rates rise, bond prices fall. Bonds with longer maturities tend to be more sensitive to changes in interest rates. All investing involves risks of fluctuating prices and the uncertainties of rates of return and yield inherent in investing. High Yield Securities, or “junk bonds”, are rated lower than investment-grade bonds because there is a greater possibility that the issuer may be unable to make interest and principal payments on those securities. As Interest Rates rise, bond prices may fall, reducing the value of the share price. Debt Securities with longer durations tend to be more sensitive to interest rate changes. High-yield bonds may be subject to more Liquidity Risk than, for example, investment-grade bonds. This may mean that investors seeking to sell their bonds will not receive a price that reflects the true value of the bonds (based on the bond’s interest rate and creditworthiness of the company).

Figure 5: Core/Core+ as represented by equal allocations (35%/35%) to the Morningstar Intermediate Core Bond Fund and Morningstar Intermediate Core Plus Bond Fund categories. Nontraditional as represented by the Morningstar Nontraditional Bond Fund category. Multi-Sector as represented by the Morningstar Multisector Bond Fund category. HY as represented by the Morningstar High Yield Bond Fund category. Loans as represented by the Morningstar Bank Loan Fund category. EM as represented by the Morningstar Emerging Markets Bond Fund category. Securitized Credit as represented by an equal-weighted portfolio of constituents from the Nontraditional and Multi-Sector bond fund categories subject to the following constraints: Inception date prior to Dec 31, 2015; At least 80% in securitized; No more than 50% in agency mortgage-backed securities; At least 2.5% in CMBS, 2.5% in ABS and 2.5% in Non-Agency RMBS; No more than 15% in corporate bonds

Performance series was calculated using the Advisor, I or Institutional Share class or cheapest share class if none of the previously listed were offered. Portfolio re-balanced annually at calendar year-end.

Disclosures

This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults (5) changes in laws and regulations and (6) changes in the policies of governments and/or regulatory authorities.

Index performance is shown for illustrative purposes only. Indices are unmanaged. They do not reflect any management, custody, transaction or other expenses, and generally assume reinvestment of dividends, income and capital gains. You cannot invest directly in an index.

Diversification does not guarantee against loss nor is it certain that a diversified portfolio will outperform a nondiversified portfolio.

Past performance is no guarantee of future results.