THE BOND BEAR MARKET HAS FINALLY ARRIVED AS CENTRAL BANKS GLOBALLY, LED BY THE FEDERAL RESERVE, HAVE BEGUN NORMALIZING MONETARY POLICY—raising policy rates and unwinding quantitative easing programs. When policy normalization is coupled with record U.S. budget deficit financing, the implication is clear: Long-term rates are set to rise. Traditional fixed income, historically the low volatility anchor to most portfolios, is no longer the safe haven it once was. Flexibility, diversification and experience in bond investing will be especially important in the years ahead.
Since 1981, when 10-year Treasury rates peaked at nearly 16%, investors in traditional fixed income have benefited from both attractive yields and capital gains. Rates fell to an all-time low of 1.37% in July 2016 before doubling in the following two years. With duration of nearly six years and a current yield of roughly 3.30%,2 the Aggregate Index is vulnerable to even modest increases in interest rates. A roughly 55 basis point rise would wipe out an entire year’s income and produce a 0% return. Ten-year yields have risen by 50bps or more in 13 quarters since the end of 2008.
CONSIDER THE NON-TRADITIONAL: UNCONSTRAINED FIXED INCOME
Thirty years ago, yields were higher and the bond market was smaller, simpler and dominated by U.S. issuers. The global bond market has since grown to over $106 trillion, with non-U.S. issuers making up nearly two-thirds of it. This broader universe offers exposure to fixed income sectors not included in the Aggregate Index—such as high yield, emerging market debt, securitized assets or even convertible bonds—that can provide higher yields, less sensitivity to interest rates and greater diversification.
With the prospect for rising rates, the time may be right to consider an unconstrained approach, implemented by a team of global specialists with experience managing a benchmark- agnostic, flexible strategy. There is no common definition for unconstrained strategies, but they are typically characterized by:
- an opportunity set encompassing the entire universe of global fixed income securities
- the freedom to allocate risk to sectors and securities only when they offer value—and to ignore them when they don’t
- the ability to actively manage duration to a greater degree than a benchmark manager might
Each manager designs a strategy to best reflect his or her strongest skills and abilities. Unfortunately, the resulting lack of similarity across strategies gathered in Morningstar’s Nontraditional Bond and Multisector Bond categories, and the historical dispersion of returns within each category, have made it more difficult for investors to identify the strategy best suited to their specific needs.
JPMorgan, for example, offers two such unconstrained strategies—varying in their focus and objectives. One is absolute return-oriented and focuses on downside protection, while the other is more strategic and designed to provide longer-term total return.
Both have performed well vs. traditional fixed income in a variety of market conditions. In particular, they have outperformed the Aggregate Index in periods of rising rates, due to active duration management and sector allocation (EXHIBIT 1).
In periods of rising rates, unconstrained strategies have delivered returns in excess of the Aggregate Index, net of fees
EXHIBIT 1: TOTAL RETURN, NET OF FEES, FOR UNCONSTRAINED FIXED INCOME STRATEGIES VS. THE AGGREGATE INDEX
Source: Bloomberg Barclays, J.P. Morgan Asset Management; data as of April 30, 2018.
Total return is represented by the JPMorgan Global Bond Opportunities Fund—R6 share class; absolute return is represented by the JPMorgan Unconstrained Debt Fund—R6 share class; the Aggregate Index is the Bloomberg Barclays US Aggregate Bond Index.
ADDING UNCONSTRAINED FIXED INCOME STRATEGIES TO A PORTFOLIO
EXHIBIT 2A and EXHIBIT 2B illustrate the potential advantages of unconstrained strategies in a portfolio context. Regardless of the direction of interest rates, adding an unconstrained approach to a more traditional fixed income allocation has the potential to improve overall risk-return characteristics.
As seen in Exhibit 2A, incorporating an absolute return strategy, with its low volatility and low correlation, into a traditional fixed income portfolio improved the risk-return trade-off. Over the time period of this analysis, September 2012 through the end of April 2018, 10-year Treasury rates rose from 1.63% to 2.95%, an increase of 132bps. Emphasizing the potential of an absolute return strategy to provide downside protection, a 30% unconstrained absolute return/70% Aggregate Index blend would have added 46bps of return annually, net of fees, to the index return, while substantially reducing volatility.
Exhibit 2B shows similar combinations of the Aggregate Index and the total return strategy over the same time horizon. A 70% unconstrained total return/30% Aggregate Index blend would have added 242bps of return annually, net of fees, to the index, with virtually no change in volatility.
Adding an unconstrained strategy (absolute or total return) to a traditional fixed income allocation can improve the risk-return trade-off
EXHIBIT 2A: RISK-RETURN FOR ABSOLUTE RETURN AND EXHIBIT 2B: RISK-RETURN FOR TOTAL RETURN AND TRADITIONAL TRADITIONAL STRATEGY BLENDS STRATEGY BLENDS
Source: J.P. Morgan Asset Management, Bloomberg; data as of April 30, 2018.
Absolute return is represented by the JPMorgan Unconstrained Debt Fund—R6 share class; total return is represented by the JPMorgan Global Bond Opportunities Fund—R6 share class; traditional fixed income is represented by the Bloomberg Barclays US Aggregate Bond Index. Risk-return charts are for September 30, 2012, to April 30, 2018, since the inception of the JPMorgan Global Bond Opportunities Fund, the longest interval for which data is available for both unconstrained strategies.
CONCLUSION: CHOOSE WISELY
When investors move from benchmark-oriented strategies to benchmark-agnostic or unconstrained strategies, they trade benchmark risk for manager risk. Picking the right manager is a key decision. The management team must be able to identify the best available investment opportunities and avoid the pitfalls and value traps within a framework of active risk management.
Return dispersion within the very broadly defined uncon- strained categories offers clear evidence of heterogeneity among managers. Individual approaches should be carefully scrutinized and understood in the context of the investor’s broader fixed income allocation and risk tolerance. We advocate strongly for the benefits of an unconstrained strategy and believe analyzing the following key factors can help investors better evaluate managers:
- depth of market expertise and investment resources
- risk management tools
- consistency of historical returns
The case for unconstrained strategies has certainly been muddied by inconsistent performance across some of the largest funds in the universe. However, as our analysis shows, unconstrained strategies can be effective complements to traditional fixed income allocations, improving risk-adjusted returns over time.