3 Key elements of a diversified bond portfolio - J.P. Morgan Asset Management

3 Key elements of a diversified bond portfolio

Contributor Priscilla Hancock

Where are rates going? What should investors do with their fixed income portfolios? The first is actually the tougher question. Market pundits have proved that predicting the path of rates is somewhat like forecasting the weather. Often the market doesn’t behave as expected, which makes market timing risky, if not costly. What should investors do with a fixed income portfolio? Our answer is simple: Rather than try to outguess the market, investors should seek to craft an all-weather bond portfolio, one that delivers the benefits of fixed income investments in a variety of scenarios.

Our model for fixed income portfolio construction, which we call the “Fixed Income Triangle,” can serve investors well across all cycles and seasons (Exhibit 1).

The Triangle depicts a diversified fixed income portfolio that looks to deliver the traditional benefits of fixed income – negative correlation to equities and low volatility – while also yielding better risk-adjusted returns over a market cycle.

Core portfolios: Low volatility, negative correlation to equity

Core portfolios form the base of the Triangle. These are traditional fixed income portfolios, which have historically exhibited negative correlation to equities and low volatility. Typically, these are high-quality bond portfolios with short to intermediate durations, such as those represented by the Barclays U.S. Aggregate Index. Today, core portfolios have trouble delivering the third benefit many investors want from fixed income – income. Yields have been hovering near historic lows for a number of years. In addition, as investors consider the potential for rising rates, they are concerned that core portfolios will begin to lose value, as they did during the taper tantrum in 2013.

Extended sectors: incremental yield, slightly higher risk

At the top of the Triangle, the extended sectors can help provide incremental yield. Sectors such as high yield and emerging market debt have historically offered significantly higher yields, and potentially higher return, than has the core. With added yield, however, comes added risk. The extended sectors traditionally have higher volatility, and often more correlation to equities, than does the core. Thus, layering an extended sector portfolio on top of a core portfolio can limit or reduce two of the key benefits of owning fixed income.

Core complement: negative correlation to the core, volatility reduction

The middle part of the Triangle, the core complement, helps to address both issues. The key to the core complement: it consists of fixed income assets that are negatively correlated to the core. Included in the complement part of the Triangle are absolute return funds, which are designed to deliver positive returns in all market conditions. Because they are negatively correlated to the core, they not only tend to perform better when rates are rising, they also act to reduce portfolio volatility.

Investment implications

Investing involves risk, including possible loss of principal. Investment returns and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Shares are bought and sold throughout the day on an exchange at market price (not NAV) through a brokerage account, and are not individually redeemed from the fund. Shares may only be redeemed directly from a fund by Authorized Participants, in very large creation/redemption units. Brokerage commissions will reduce returns.

Investments in bonds and other debt securities will change in value based on changes in interest rates. If rates rise, the value of these investments generally drops.

International investing bears greater risk due to social, economic, regulatory and political instability in countries in "emerging markets." This makes emerging market securities more volatile and less liquid developed market securities. Changes in exchange rates and differences in accounting and taxation policies outside the U.S. can also affect returns.

Securities rated below investment grade are considered "high-yield," "non-investment grade," "below investment-grade," or "junk bonds." They generally are rated in the fifth or lower rating categories of Standard & Poor's and Moody's Investors Service. Although these securities tend to provide higher yields than higher rated securities, they tend to carry greater risk.

Related funds

Global Bond Opportunities Fund
Broaden the borders of your bond portfolio. The Fund provides flexible, high-conviction exposure across more than 15 fixed income sectors and 50 countries.
Strategic Income Opportunities Fund
Complement your core. With an absolute-return-oriented approach to fixed income investing, invests flexibly across a diverse set of fixed income strategies, taking advantage of the best opportunities across all market environments.
Core Bond Fund
Quality at the core. A value-driven approach that emphasizes intermediate bonds of the highest quality, the Fund serves as a foundation for investors seeking a well-diversified portfolio.