Unconstrained Fixed Income: Perspectives on Duration

Unconstrained Fixed Income: Perspectives on Duration

Matt Toms

Matt Toms, CFA

Chief Investment Officer, Fixed Income

Voya's Unconstrained Fixed Income strategy seeks to produce consistent returns over full market cycles, with low correlations to interest rates and equities.

Highlights

  • Many unconstrained fixed income product offerings, while offering protection against rising rates, generally focus on short-term returns.
  • Clearly defined risk tolerances—not specific return targets—are most important when approaching today’s challenging fixed income markets.
  • The Voya Unconstrained Fixed Income strategy’s duration range (centered around 2 years) is designed to stay within well-defined risk and return parameters.

Establishing risk parameters

For many investors, the primary function of fixed income is to protect wealth and achieve moderate returns over the long term while avoiding downside risk. When investors instead focus on maximizing short-term returns, they do so at the expense of taking on more risk.

We believe that establishing prudent risk tolerances before setting return expectations is likely to lead to more stable and reliable investment returns. This is the guiding principle behind the Voya Unconstrained Fixed Income strategy: first identify a rational level of risk tolerance for the client and adjust return expectations in each market for that stated risk tolerance. Then, using the risk tolerance and return expectations, craft an optimized portfolio of fixed income securities that seeks to produce stable returns in any market environment.

Rationale for risk objective

The central objective of the Voya Unconstrained Fixed Income strategy is not simply to protect investors from rising rates, but also to produce positive performance regardless of the market environment. By taking a longer-term perspective the strategy is able to establish a clear risk tolerance before considering specific, quantifiable return objectives. Accordingly, for the unconstrained strategy, we expect volatility to be in line with traditional fixed income, which is represented by the long-term volatility range of the Bloomberg Barclays U.S. Aggregate Bond Index (Fig. 1).

Figure 1: The risk objective of Voya Unconstrained Fixed Income derives from market-based measures of volatility
Rolling 1-year Bloomberg U.S. Aggregate Bond Index standard deviation
Figure 1: The risk objective of Voya Unconstrained Fixed Income derives from market-based measures of volatility

Source: Bloomberg. As of 04/30/22.

Even with the added flexibility afforded by such an approach, we believe an unconstrained strategy still should behave like a fixed income investment and should exhibit a risk profile consistent with traditional fixed income assets. Using risk tolerance as our primary guide, we focus on producing more reliable returns while attempting to minimize downside risk (target excess return 300–400 basis points (bp)).

We intend for the unconstrained strategy to offset volatile equity markets in a fashion similar to traditional fixed income strategies, as well as to produce consistent returns over a full market cycle. In addition, the flexibility of the strategy and its tightly managed risk profile are intended to provide investors with a more stable return experience than traditional fixed income products, i.e., enhanced downside risk protection and limited volatility.

Rationale for duration range

With the rationale for the risk objective now established, we can move to the strategy’s central tendency for duration, which is set at 2 years. This is based on long-term data that demonstrate clear, recognized diversification benefits associated with mixing duration risk and credit risk. Fig. 2 shows a generally negative correlation over the last 15 years between Treasury securities, a gauge of duration risk; and corporate bond spreads, a gauge of credit risk.

Figure 2: The negative correlation between credit and duration risk offers a potential diversification benefit
Rolling 3M correlation of U.S. 5Y Treasury and corporate spreads
Figure 2: The negative correlation between credit and duration risk offers a potential diversification benefit

Source: Bloomberg. As of 04/30/22.

Assuming the correlation of Fig. 2 holds true in the future, you can then plot the projected volatility of a hypothetical portfolio as duration changes. The starred point on the orange “historical volatility” line of Fig. 3 shows that a portfolio of investment-grade and below-investment-grade fixed income securities (“diversified portfolio”) exhibits its minimum volatility at a duration of about 2 years, which is why this point represents the strategy’s duration central tendency. Keeping credit risk constant, overall portfolio risk increases as duration rises or falls from this point. We believe 2 years represents an optimal balance of risk and reward over the long term.

While a duration of 2 years is the long-term central tendency, given the unconstrained nature of the strategy, we can still adjust duration above and below this point in the short term. However, we limit the portfolio’s range of duration to -2 to 6 years, which we have determined to be optimal for staying within the stated risk objective of 200–700 bp as outlined above. We believe this range maximizes flexibility while ensuring that the strategy remains within its risk budget even as market conditions change.

A wider duration range brings significant potential to exceed the risk budget and/or limits the strategy’s flexibility.

Figure 3: 2 years represents the unconstrained strategy’s optimal duration
Hypothetical portfolio volatility vs. duration
Figure 3: 2 years represents the unconstrained strategy’s optimal duration

Source: Voya Investment Management. Shown for illustrative purposes only.

This can be illustrated best by looking at a point outside the strategy’s duration range. For example, the -4 year duration point has an absolute volatility just short of 700 bp. While this falls within the permitted volatility range for the strategy, it constrains the portfolio in two significant ways:

  • Provides no room to further increase credit risk: The strategy’s unconstrained mandate is designed to allow for tactical increases or decreases of credit risk from the diversified portfolio. Because credit risk and positive duration risk are negatively correlated, it follows that credit risk and negative duration risk are positively correlated. Therefore, increasing credit risk beyond the diversified portfolio would increase overall risk and likely cause the portfolio’s absolute volatility to exceed the 700 bp maximum.
  • Assumes long-term correlations always hold: While Fig. 2 shows that duration and credit risk have a consistent, long-term negative correlation, it also makes clear that this relationship is volatile. At times this correlation has moved close to zero and occasionally has turned positive. It cannot be assumed that the potential diversification benefits of this correlation will always hold; at certain times those benefits may erode or reverse. The grey line of Fig. 3 shows what happens to portfolio risk in a worst-case scenario — when the correlation benefits in the diversified portfolio disappear. It is important to appreciate and utilize the long-term diversification benefits that correlations provide, but it also is important to recognize that these benefits are not constant or permanent. Limiting duration to the range shown in Fig. 2 allows for appropriate flexibility while providing a cushion to help the portfolio comply with its absolute risk objective, should the credit/duration correlation benefits diminish.

These two points highlight the dangers of exceedingly wide duration bands. The Voya Unconstrained Fixed Income strategy’s duration range is designed to stay within well-defined risk and return parameters. This design provides the necessary flexibility to tactically adjust risk exposures in the portfolio as market conditions change. We believe that centering the duration range around 2 years provides for optimal diversification of portfolio risks without introducing the potential for greater volatility that could result from overly wide duration bands.

Clearly defined risk tolerances, not specific return targets, are most important when approaching today’s challenging fixed income markets. The Voya Unconstrained Fixed Income strategy’s flexible investment mandate, guided by carefully designed risk parameters, takes account of these challenges, and seeks to deliver long-term value to investors.

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Past performance does not guarantee future results. 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. The opinions, views and information expressed in this commentary regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Fund holdings are fluid and are subject to daily change based on market conditions and other factors.

Risks of Unconstrained Fixed Income investing. The principal risks are generally those attributable to bond investing. Holdings are subject to market, issuer, credit, prepayment, extension, and other risks, and their values may fluctuate. Market risk is the risk that securities may decline in value due to factors affecting the securities markets or particular industries. Issuer risk is the risk that the value of a security may decline for reasons specific to the issuer, such as changes in its financial condition. The strategy may invest in mortgage-related securities, which can be paid off early if the borrowers on the underlying mortgages pay off their mortgages sooner than scheduled. If interest rates are falling, the strategy will be forced to reinvest this money at lower yields. Conversely, if interest rates are rising, the expected principal payments will slow, thereby locking in the coupon rate at below market levels and extending the security’s life and duration while reducing its market value. High yield bonds carry particular market risks and may experience greater volatility in market value than investment grade bonds. Foreign investments could be riskier than U.S. investments because of exchange rate, political, economics, liquidity, and regulatory risks. Additionally, investments in emerging market countries are riskier than other foreign investments because the political and economic systems in emerging market countries are less stable. The strategy employs a quantitative investment process. The process is based on a collection of proprietary computer programs, or models, that calculate expected return rankings based on variables such as earnings growth prospects, valuation, and relative strength. Data imprecision, software or other technology malfunctions, programming inaccuracies and similar circumstances may impair the performance of these systems, which may negatively affect performance. Furthermore, there can be no assurance that the quantitative models used in managing the strategy will perform as anticipated or enable the strategy to achieve its objective.

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