This commentary is available as a PDF here.
- Bonds have historically served as a position of safety, an income generator, a diversifier, and a flight-to-safety hedge.
- In a “lower for longer” era, many of these objectives may no longer be met by a core fixed income allocation.
- We introduce the idea of unbundling core fixed income into each objective, building a portfolio to meet the objective, and rebuilding a composite portfolio from the sleeves that aligns with our personal needs in fixed income.
Last week’s commentary (Bond Returns: Don’t Be Jealous, Be Worried) generated a significant number of inbound inquiries related to our thoughts on how a core fixed income portfolio could be replaced. With this week’s commentary, we wanted to present our “unbundle and rebuild” philosophy, an approach we utilize in our Total Return portfolio which we offer as a core bond alternative. We also offer strategies that hone in on specific fixed income objectives (e.g. Target Excess Yield, Multi-Asset Income, and Dynamic Alternatives).
With the benefit of hindsight, there have been few investments as attractive as core U.S. fixed income over the last 30 years. Capital preservation, income, diversification, and even hedging volatility: was there anything fixed income did not provide?
With 10-year U.S. Treasury rates nearing all-time lows, however, the cost/benefit math may be less in favor of this once heroic asset class. Our fear is not necessarily rising rates, rate volatility, or even the risk of a spike in inflation. Rather, quite simply, low present rates imply low forward returns, making large allocations to traditional fixed income a potentially costly choice.
Living in the unprecedented era of globalized, experimental central bank policy, we believe reexamining the size and role of fixed income within our portfolios is warranted. Given all that core fixed income has achieved for investors historically, is there a way to go about replacing this exposure while simultaneously reducing our exposure to interest rates?
At Newfound, we believe the answer is to unbundle and rebuild: unbundle the objectives, solve for them individually, and rebuild a solution from the sleeves.
The first step of the process is to build a solution for each of the four objectives.
Short-term fixed income is still one of the best ways to preserve capital. Positions in ETFs such as GSY and MINT, which focus on finding enhanced yield opportunities in the short duration space, may help an investor achieve the necessary safety while at least dampening the impact of inflation.
To satisfy income needs in today’s interest rate environment, investors should look towards extended fixed income sectors like high yield bonds (HYG and HYS), bank loans (BKLN), emerging market debt (PCY and EMLC), and high yield municipals (HYD). While each of these sectors comes with its own significant idiosyncratic risk, can actively managed and thoughtfully diversified portfolio of such exposures can help mitigate these risks.
The continued proliferation of exchange traded funds means that many diversifying, alternative strategies that were once only available in hedge fund structures are now available to all investors. The benefit of many of these approaches is that they can offer diversification to both traditional equities and fixed income. We view the goal of this sleeve as creating a steady “LIBOR plus” style return that has little exposure to traditional equities or fixed income.
The categories we look to employ at Newfound include: hedge fund beta (HDG), equity long/short (FTLS, RALS), dividend swaps (DIVY), event-driven (MNA), volatility (HVPW), currency carry (DBV), and floating rate bonds (FLOT). Again, while each of these approaches comes with its own risks, by diversifying across many we can control our overall volatility profile and exposure to traditional market risks.
Extreme care must be taken in building this sleeve, as historical volatility and correlations can be extremely misleading measures of risk and diversification. Many alternatives have significant jump risk: the risk of a large, instantaneous loss. Within our own portfolios, our models of risk in this sleeve typically focus on worst-case scenarios (max drawdown / conditional value-at-risk) and crashing correlations.
For many investors, Treasuries serve as the asset class of last resort, giving it crisis alpha qualities that make it a tremendous diversifier against both instantaneous and prolonged equity crashes. In this sleeve, we believe that a position in longer-dated Treasuries is still warranted (e.g. IEF or TLT), but other exposures may also work well, including managed futures (WDTI), exposure to the U.S. dollar (USDU), equity long/shorts that run a negative beta (BTAL), or even a managed volatility strategy (we use a dynamic combination of VIX and XIV).
The benefit of an unbundle and rebuild approach is that it allows us not only to construct out the portfolio for each objective as we see fit, but also to rebuild our overall allocation with greater consideration of our personal risk tolerances and objectives. For example, the Barclays U.S. Aggregate has a 60%+ allocation in U.S. Government Treasuries and Agencies, indicating a reduced potential for current income but a strong utility as a flight-to-safety hedge.
A retiree, for example, might be less concerned about having a flight-to-safety hedge, as their overall profile is already extremely conservative, than they are about finding and delivering stable income. They may choose to allocate more towards the income sleeve than the hedging sleeve.
A growth investor, on the other hand, may have no real need for current income, and is only using the fixed income exposure to ballast their significant equity exposure. In this case, they may choose to put a larger focus on the diversification and hedging sleeves.
At Newfound, we employ this unbundle and rebuild approach in our Total Return portfolio. We focus on specifically building sleeves that meet the income, diversification, and hedging objectives, and then use a simple volatility-weighting portfolio construction process such that each sleeve contributes equally to the overall risk of the portfolio.
By doing so, we believe that we can create a portfolio with an overall risk profile similar to that of core fixed income, but with a more diversified source of returns, significantly reducing our overall exposure and reliance on interest rates as a return driver.