Few today remember the name Kuhn, Loeb & Co., a storied Wall Street investment bank founded just after the Civil War. The firm was a major player in the bond markets for over a century, until its ultimate sale to Lehman Brothers in 1977. 1 Following the demise of Lehman Brothers in 2008, one might assume that the DNA of Kuhn, Loeb & Co. had finally been extinguished for good.
Not so.
A small seed planted by the firm’s bond research department in 1973 took hold and has grown into the mighty oak known as the Aggregate Bond Index (the “Agg”). For decades, first under the name of Lehman Brothers, then Barclays and now Bloomberg, this market benchmark has become synonymous with fixed income investing. Fifty years after the index’s creation, huge pools of capital are still allocated against it.
But there’s a problem. The key components of the Aggregate Index have remained largely unchanged over the years; the last major update was the addition of mortgage-backed securities in the early 1980s. The bond market, however, has grown and diversified in many ways since then. This presents a dilemma for investors: The public benchmark originally associated with the broad market is no longer fully representative of the opportunities within fixed income (Exhibit 1).
In this article, we explore how fixed income investors might be able to look beyond the traditional boundaries of core fixed income – as defined by the Aggregate Index – and take advantage of today’s more diverse bond market to meet their primary objectives of income, stability and diversification.
The U.S. fixed income market is more diversified than the Aggregate Bond Index
Exhibit 1: Sector composition of the U.S. fixed income market
Source: J.P. Morgan Asset Management, Bloomberg, SIFMA; data as of December 31, 2021. The Credit Suisse Leveraged Loan Index and the ICE BofA US Convertible Index were used to illustrate the amount outstanding for bank loans and convertibles, respectively.
Past success makes for a challenging future
Why does an index that only partially represents the fixed income opportunity set still enjoy such widespread acceptance? Aside from simple habit, there are some very good reasons for the Aggregate’s longevity, starting with strong historical performance (Exhibit 2). For nearly four decades, bond investors have benefited from disinflation and declining interest rates, and traditional fixed income strategies built around the Aggregate Index have consistently delivered returns in excess of expectations. Another reason is diversification: During the same period, risk-taking was focused on public equity, and the high quality bond sectors that compose the benchmark delivered consistently low or negative correlations to equities. 2
But this long winning streak has had consequences. With each leg down in interest rates, the core bond market has seen its yield decline and its duration increase – offering less income for greater risk. The composition of the Aggregate Index has tilted toward government bonds and government-guaranteed mortgages, effectively concentrating its risk exposures toward interest rate risk and away from credit risk. Now that rates have begun to rise, this embedded riskiness is manifesting itself in a period of sharply negative performance.
The composition of the Aggregate Index drove its long-term success but is now a headwind
Exhibit 2: Calendar year performance of the Bloomberg US Aggregate Index from 1980–2022
Source: Barclays Live, J.P. Morgan Asset Management; data as of May 1, 2022.
Some investors will endure recent negative performance and wait patiently for the benefits of higher yields to pay them back for short-term capital losses. Other investors will seek refuge from rising rates and high volatility by moving from traditional core to more defensive fixed income sectors, such as low duration. Regardless, over the longer term, the markets will find balance, rates will stop rising, and a new decision point will emerge: whether to stick with the traditional core represented by the Aggregate Index or seek a new and more effective exposure to the fixed income market.
Investors know what they want from bonds: income, stability and diversification. The past success of the Aggregate Index in meeting these objectives is as much an artifact of the historical environment as it is an intrinsic virtue of the benchmark itself. Without the tailwind of decades of falling rates, the future environment for core fixed income is unlikely to be quite as favorable.
Maximizing the strategic benefits of fixed income requires tactical flexibility
Forty years ago, a combination of U.S. Treasuries, investment grade corporate bonds and agency-backed mortgages was a reasonable approximation of the investible fixed income universe. While investors had little choice but to accept the risk-return profile offered by this particular mix of sectors, the widespread adoption of active management at least allowed them to improve performance relative to the benchmark itself.
In today’s market, however, an actively managed core strategy on its own cannot provide an effective representation of the expanded opportunity set. The simple fact is that the noncore sectors have grown too large; high yield bonds, convertible bonds, bank loans, private placements, non-agency and private mortgages, bank capital and subordinated debt, emerging market debt, private direct lending and structured credit are all significant markets in their own right. A passive core strategy shuns these opportunities altogether. And while an active core or core-plus strategy will have flexibility to incorporate these sectors at the margin, the use of the Aggregate Index as a benchmark will limit how much diversification can be achieved.
The full spectrum of today’s fixed income market offers far more than marginal risk exposures around the core; it is now an essential element to achieving key objectives:
- Delivering current income in the form of coupon payments
- Preserving liquidity and stability, through low absolute volatility and high credit quality
- Offering portfolio diversification, through a low or negative correlation to equities
The value of expanding the opportunity set is further enhanced if investors are also able to move capital across market sectors as economic cycles and market conditions change. Individual sectors of the fixed income market rarely provide income, stability and diversification at the same time. Most offer one, or at most two, of these characteristics – and the degree will change over time.
No single fixed income sector provides income, stability and diversification
Exhibit 3: Exposure of fixed income asset classes to key investor objectives (dark green is highest exposure; red is lowest)
Source: J.P. Morgan Asset Management. For illustrative purposes only.
Exhibit 3 shows that none of the columns effectively deliver all three – confirming that no single fixed income sector serves all purposes. As a result, bond investors should move in the direction of a strategic fixed income allocation that allows for exposure to as many sectors as possible while providing greater flexibility to managers.
Benchmarks vs. objectives in portfolio construction
It would be naive to think that traditional market benchmarks will simply disappear in favor of portfolios built exclusively around the key portfolio objectives. At the same time, the proliferation of market sectors makes allocation to each one individually operationally challenging and potentially restrictive for active managers. Instead, allocators may want to incorporate broader, more flexible mandates that collectively capture the broader opportunity set using “supersectors” that contain multiple individual market sectors (Exhibit 4).
We identify several broad supersectors of the fixed income market, each of which contains individual sectors with key commonalities:
- Low duration focuses on the short-duration (approximately one to three years) segment of high quality fixed income, seeking to provide stability while delivering defensive positioning and high liquidity.
- Core centers around the traditional Aggregate Index sectors: Treasuries, investment grade credit and securitized credit. It offers a balance of income, stability and yield with high quality and liquidity.
- Diversified long duration/Liability-driven investing captures the longer-maturity segments of the investment grade markets, which are of particular interest to liability hedgers and those seeking risk diversification from duration.
- Multi-sector credit/income ranges from investment grade to high yield, bank loans, preferred equity and convertibles. It offers high levels of income from diversified credit risk, capital structure and complexity premia.
- Alternative credit seeks to maximize yield and alpha potential by investing in esoteric and less liquid sectors of the credit markets, including mezzanine debt and private direct lending.
- Unconstrained/Tactical Asset Allocation is the most flexible mandate, with ability to select from securities and sectors across the full opportunity set, usually targeting absolute returns or maximizing alpha relative to a broad market benchmark.
Segmenting the fixed income opportunity set
Exhibit 4: Illustrating broad supersectors of the fixed income market
Source: J.P. Morgan Asset Management. For illustrative purposes only.
There are two key advantages of investing across supersectors. First, the structural diversification allows portfolios to more effectively capture the broad objectives of stability, income and diversification (Exhibit 5). Second, active managers should be able to generate improved risk-adjusted returns by allocating to the best securities within each specific sector while also using tactical flexibility to tilt exposures across sectors as market conditions change. This diversified and flexible model is well suited to reaching key objectives rather than simply tracking or beating a particular market benchmark.
Consider how the supersectors are more effective than individual asset classes
Exhibit 5: Alignment of fixed income supersectors with key investor objectives
Source: J.P. Morgan Asset Management. For illustrative purposes only.
Returning to the original premise of this paper, the role of the Aggregate benchmark and core bonds in general does not disappear in this model. The key sectors of the core – Treasuries, investment grade credit and mortgages – continue to play a key role in fixed income portfolios, given the depth and liquidity of these markets, their high quality and the potential for active management to improve returns. Bundling them together in a single mandate makes sense when a skilled active manager can take advantage of the breadth of this opportunity set. It is also the case that dedicated exposure to specific sectors can still be valuable when there is a strategic need to hold a particular asset class or there is a high level of specialized skill present.
Traditional fixed income benchmarks have delivered results far beyond expectations for several decades. But much of the success enjoyed by core bond investors can be attributed to a specific period of economic history that is unlikely to be repeated. As the market transitions through a phase of inflation and rising rates, investors have an opportunity to reorient their fixed income strategy around the key objectives of income, stability and diversification while taking advantage of a far more diverse opportunity set. Allocating with these objectives in mind should help balance the safety of traditional core assets with the income and diversification potential of today’s bond market – not yesterday’s benchmark.
1 Although possibly apocryphal, there is an amusing quote associated with this episode. When asked how many people worked at Kuhn, Loeb & Co., one of the senior partners responded dryly, “about half.”
2 When Harry Markowitz first published his pioneering work on Modern Portfolio Theory in 1952, the investment management industry was, to be charitable, unready for the insights that he offered. But with time and further refinement, the use of mean-variance optimization (MVO) to build diversified asset allocations began to catch on among long-term investors. Today, MVO and its descendants remain the bedrock on which the design and implementation of strategic asset allocations take place. In this system, the high quality and positive duration of the Aggregate Index were valuable attributes for asset allocators looking to diversify portfolios that were tilted to higher returning but riskier equities.