Maggie McRae

Many investors think of fixed income as a boring, plain-Jane asset class, but what they don’t realize is that not all fixed income asset classes provide the same benefits to portfolios. In fact, there has been vast dispersion across sub-asset classes in terms of the risk-return tradeoff experienced over the last 10 years (e.g., TIPS, short duration, high yield, bank loans, EMD, core fixed income, etc.). Each flavor of fixed income embodies a different set of characteristics, which we at Verus refer to as “levers.” These levers can help explain performance and how each style is expected to behave in various environments. Ultimately, this framework can help investors customize their portfolio by lever type and corresponding asset class selection to best fit their needs, helping to create a more tailored experience.

What are the “levers”?

When thinking about pairing asset classes together thoughtfully, a key question to ask might be: why is fixed income held in the first place? In other words, what is the goal of the allocation? Common goals include capital preservation, income, liquidity, volatility reduction, and diversification of equity risk. These attributes are the “levers” that make up this framework.

Based on an investor’s goals, some asset classes may be more practical than others as each brings a different set of attributes. For example, core fixed income provides income, acts a diversifier and can reduce overall portfolio volatility, whereas high yield delivers a credit risk premium in the form of higher coupon payments, although the asset class can exhibit equity-like return patterns. Using this example, an investor who is more concerned with high income and less concerned with increased volatility may prefer high yield. In this framework, asset class attributes are standardized by ranking the degree to which each asset class embodies each lever (see chart below).

These asset classes can also have vastly different risk-return profiles, which makes sense given their different attributes. For example, Verus forecasts more than a 5% dispersion in expected standard deviation between core fixed income and high yield over the next 10 years.

Assessing the levers in this framework can help explain performance in various market environments and assist in aligning expectations accordingly. For example, in a normal market environment, high yield managers will typically deliver more income (expressed by a higher credit premium due to greater borrower risk) than core fixed-income managers, which provides a diversified exposure to Treasuries, structured product and investment-grade corporate bonds. In a “flight-to-quality” rally, core fixed income should be expected to outperform high yield due to higher Treasury exposure (providing higher capital preservation and liquidity in case of a credit event).

Summary

Fixed income is not a homogenous asset class; there are many flavors that can bring different experiences to portfolios. The levers framework can be used to understand the different roles various fixed income asset classes can play in portfolios. Additionally, analyzing the expected behavior of each asset class can help create thoughtful construction of fixed income portfolios.



McRae is a member of the manager research group at Verus Investments, where she conducts research, analysis, and evaluation of investment managers across traditional asset classes. McRae has over seven years of experience in performing due diligence on a wide variety of asset classes, including global and domestic fixed income and equity investments.