Active management can encourage allocators to act on and capture compelling opportunities by reducing concerns about getting the timing exactly right.
There is a basic distinction to be drawn between asset allocation and active management, which are separate tasks with different objectives and time horizons. Asset allocators invest strategically, positioning portfolios across market sectors to capture returns and diversification over a longer horizon; active managers generally seek bottom-up alpha within a particular sector over a shorter horizon. When confronted with a highly dynamic market environment, they can easily reach different judgements regarding the merits of an investment.
These differing perspectives, rather than acting as a barrier to decisive action, can actually be quite helpful to the allocation process. Active management can encourage allocators to act on and capture compelling opportunities by reducing concerns about getting the timing exactly right. Today’s bond market, turned upside-down by the Federal Reserve’s aggressive monetary policy, highlights the benefits of pairing strategic, long-term investing with tactical, short-term moves by active managers.
The current market presents an uncommon opportunity
The bond market currently presents an opportunity to capture historically attractive yields with relatively low risk. As the Federal Reserve (Fed) has fought against inflation, yields have moved significantly higher over the past year. From this point, long-term expectations for fixed income returns have risen as well, once again making bonds a significant driver of portfolio returns (Exhibit 1).
For an allocator, the risk-return trade-off seems favorable. Strategically, a pivot towards fixed income results in a more defensive asset allocation with greater income and more liquidity. Even if interest rates rise from here, a low- to moderate-duration portfolio offers enough yield to recover modest losses in short order. Conversely, if rates decline, fixed income assets could generate positive total returns in addition to their compelling yield.
Question one: Is the yield curve priced correctly?
Since the economic environment remains highly uncertain, allocators will want to balance the compelling current opportunity against the risk of adding exposure to bonds potentially at the wrong time or in the wrong sectors. It is here that active management can offer valuable support. Allocators who may be struggling to decide if the bond market is accurately pricing key macroeconomic risks can rely on active managers to position duration and curve risk according to the latest data, and to tilt their portfolios toward specific sectors and credits that offer attractive relative value.
Recall that at the beginning of the year bond yields were suppressed by monetary policy that featured exceptionally low rates at the front of the curve and quantitative easing that brought down yields across longer maturities. As monetary policy has responded to higher inflation, with higher short-term rates accompanied by quantitative tightening, bond markets have recalibrated (Exhibit 2).
Currently, the market broadly reflects the consensus expectations for Fed policy: a slowing pace of increases that reaches a terminal rate in the vicinity of 5% and remains there for the better part of a year. Unlike earlier in the cycle, the market no longer seems to be playing catch up. While no one knows the precise future trajectory of inflation and subsequent policy responses, going forward we expect incremental adjustments as new data emerges and the Fed clarifies its objectives. Allocators should therefore feel more confident allocating capital to fixed income, while allowing active managers to respond in real time to new information.
Question two: How far out the curve?
The bond market is offering very different entry points depending on which part of the yield curve is being targeted. The current inversion of the yield curve may put a thumb on the scale in favor of shorter-duration fixed income strategies where yields are being supported by the Fed’s aggressive monetary policy. The opportunity to generate such significant yield with so little interest rate risk is rare. However, there can also be benefits to moving a bit further out the curve, such as locking in attractive yields over a longer investment horizon and positioning to benefit from declining rates in the future.
For most asset allocators, the question boils down to preferences for defensive liquidity, yield or total return.
- Shorter-duration strategies currently offer an unusual mix defensive liquidity and yield, but these benefits will diminish if and when rates fall. Long-term investors using such strategies are implicitly anticipating opportunities to make use of the liquidity and lock in higher yields in the future.
- Moderate-duration core fixed income offers a similar level of current yield, but effectively locks it in over a longer horizon. The increased interest rate risk in this approach suggests a view that the market is more-or-less correctly priced and that interest rates are more likely to follow the path implied by forward rates and decline over the medium term.
- Long-duration strategies must contend with the current inversion of the yield curve, which is offering investors less yield compared to less risky lower-duration options. This choice would align with a view that a recession may be deeper than is currently priced in and/or that a broad decline in interest rates will be front-loaded, generating high total returns that offset the lower yield.
Question three: How much credit exposure?
After thinking through yield curve positioning, investors need to consider how much credit risk exposure they want. While credit yields have widened materially during the past year, they remain inside of historical levels associated with a credit downturn. It is not clear that they fully reflect the risk of a recession in which downgrade and default risks rise sharply (Exhibit 3).
Exhibit 3 shows that yields are currently at some of the highest levels of the past 10 years and well above the median level experienced during that time. However, we must recognize that the past 10 years did not include a widespread credit downturn such as was seen during the global financial crisis (GFC). Compared with those extremes, current credit spreads may not seem quite so cheap, and have room to widen further in a possible recession (though there is little evidence to suggest that we are heading for a repeat of the widespread credit downturn seen in the GFC).
Regardless, that does not mean that investors should necessarily wait until the entry point becomes too good to ignore. Periods of historically wide credit spreads often exhibit limited liquidity and modest transaction volume, making it unlikely that any particular investor – let alone the broader population – will be able to capture the most attractive levels. Once investors begin buying en masse, credit spreads tend to tighten rapidly.
Allocators looking at opportunities in credit (currently or prospectively) may want to view the entry point as a process that incorporates both top-down allocation decisions and thoughtful manager selection. Three broad principles can serve as a guide: Start early, cast a wide net, and fully exploit the potential of active management. Allocators can:
Add exposure to diversified active fixed income strategies that are well positioned for the current environment and have the flexibility to respond to changing conditions. Active short duration and core strategies can make use of high-quality Treasury and securitized sectors to maintain a liquid, low-risk portfolio while seeking opportunities in riskier credit sectors.
Incrementally add to active credit strategies across the full spectrum of spread sectors – not just investment grade corporate credit. Dedicated exposure to sectors like securitized fixed income and high yield can diversify risk and take advantage of ratings migration into and out of investment grade.
Incorporate dynamic active strategies that seek advantages not only within specific sectors of the bond market, but which have the flexibility to move across sectors to find the most compelling opportunities. Opportunistic, income-focused, and multi-sector credit strategies are well positioned to move capital dynamically across time.
Fine-tuning an allocation strategy with active management
Asset allocators understand that waiting for absolute certainly is a sure way to miss out on opportunities. Current yields and long-term expected returns from fixed income are more compelling than at any time in recent memory. Finding ways to capitalize on this environment will make a huge difference in reaching investment objectives.
But a certain amount of uncertainty remains with respect to Fed policy, the path of interest rates and the fair price of credit risk. This calls for a thoughtful approach to sequencing market exposure. Short-term uncertainty is not a reason to avoid the market but is a reason to employ active managers who can pro-actively respond to changing conditions. The ability to fine-tune risk exposures inside the portfolio can turn uncertainty into opportunity and give confidence to the allocation process when it is most necessary.