Op-Ed: Should Allocators Un-Core Their Core Bond Portfolio?
For the past several months, industry conferences, summits, and roundtables have inspired peers and experts to share ideas on hot topics, such as how to manage due diligence during a pandemic, how to maintain team chemistry and productivity in a virtual environment, and how to encourage diversity and inclusion initiatives in the investment program. Recently, another hot topic has emerged: What should allocators do with their core bond portfolio?
A core bond allocation is supposed to be the “worry-free” part of a diversified portfolio. Treasuries and high-quality credit bonds are expected to reliably produce income, provide liquidity, and help a portfolio protect against large drawdowns. However, these portfolio benefits are now being called into question. The once “sleep at night” allocation is now a source of consternation. With yields at historic lows, bonds are not generating meaningful income. And with any economic improvement or reversal of Fed action, rates could rise and bond prices could fall, meaning core bonds could actually act as a portfolio disrupter rather than a portfolio stabilizer.
Mark Cagwin, sage director of SSM Health’s investment program, said, “We are forecasting low returns in our core bond portfolio, yet there are certain scenarios, including unexpected inflation, in which core bonds could have significant downside risk. This asymmetric risk/return profile is concerning.”
In looking at the current characteristics of the Barclays Aggregate Index (AGG), Cagwin’s concerns are understandable. Three-time Chief Investment Officer Knowledge Broker Mika Malone of Meketa Investment Group provided additional context: “According to our data source, Investment Metrics, the Barclays Aggregate Index currently has an average duration of 6.5 years and a current yield to maturity of 1.2%. If the best predictor of future returns of bonds is the current yield, investors will likely assign a sub 2% return for AGG-like investments over the next market cycle. Many of our clients are asking whether or not they should accept the downside risks in core bonds just to earn a return between 1% and 2%.” This is the asymmetric risk/return scenario that concerns Cagwin.
Malone added, “Each institution will address this concern differently depending on their risk tolerance and return objectives. We are spending a considerable amount of time helping our clients determine the most appropriate course of action given their unique set of circumstances.”
For allocators managing a 60% equity and 40% core bond portfolio and needing to hit a 6% to 7% return target, the outlook for core bonds represents another challenge. Specifically, if the 40% core bond allocation does in fact return less than 2%, the portfolio’s 60% equity allocation must generate double digit gains for the institution to meet its return objectives.
Given these obstacles and conditions, many investment offices are discussing with their boards and committees what approach to take regarding the core bond allocation. Common considerations include:
Do nothing (may work or even thrive if rates decline further, but could possibly subject investors to low returns and greater than normal downside risks);
Shift the core bond allocation to cash (protecting against declining bond prices might be prudent, but earning 0% to 1% is typically not an objective of an investment office);
Increase the use of diversifying hedge funds for portfolio optimization and downside risk protection (could be effective, but paying high fees in a low risk-free environment warrants caution; see Op-Ed: Using the Risk-Free Rate as a Basis to Examine Hedge Fund Costs); and
Take more risk by increasing the portfolio’s allocation to credit, equities, or private investments (what could possibly go wrong with this approach?).
But here is one more alternative to consider: Un-core your core bond allocation by barbelling the Barclays Aggregate Index.
To implement this approach, I encourage allocators to begin by separating the Treasury and non-Treasury (credit) components of the core bond exposure (see OP-ED: Disaggregate Your ‘Aggregate’ Composite).
According to data provided by Meketa Investment Group through Investment Metrics, the Barclays Aggregate Index currently has 39% exposure to Treasuries and 61% exposure to credit-focused investments. The primary risk relating to the Treasury portion of the index is duration risk. Treasury bonds will do well in a falling rate environment, but a rising rate environment would create a headwind for Treasuries.
The non-Treasury allocation also has duration risk, but default risk (credit risk) for this portion of the index is the higher concern for investors. Downgrades or a spike in default rates would have a negative effect on the returns of the non-Treasury weighting of the index. As mentioned above, this mix of investments is currently yielding 1.2% with a duration of 6.5 years. Investors are concerned about taking the duration and credit risks just to earn a sub-2% return for the next market cycle.
How can investors build a fixed income allocation that can preserve liquidity and generate more income than the AGG without significantly increasing portfolio risks? One way might be to barbell the AGG. This can be achieved by investing the AGG’s Treasury weighting (39%) in cash and the AGG’s non-Treasury allocation (61%) in higher yielding credit instruments, such as a high-yield bonds.
In other words, investors can synthetically create, or at least approximate, the risk and return characteristics of the AGG by blending cash and higher yielding investments. By doing so, an investor can build a fixed income allocation that has a higher expected return than the AGG without exposing the portfolio to meaningfully more risk.
According to Malone, “Meketa’s forward-looking return forecast for high-yield bonds is 4.9% with a 10% standard deviation. We are forecasting just over a 1% return for cash equivalents.” Using Meketa’s forecast, an investor splitting their AGG weighting between cash (40%) and high yield (60%) could build a fixed-income allocation that has an expected return of 3.5% (with approximately the same standard deviation as the AGG). The 3.5% return is materially better than the current 1.2% yield to maturity of the AGG.
In addition to having a higher expected return, the barbell strategy should respond similarly to or better than the AGG under different scenarios. If rates drop, the AGG will do well. But so will the barbelled portfolio as the high-yield allocation will respond very well to declining rates and possibly well enough to offset the low return of the cash allocation. If rates rise or if credit does poorly, both the AGG and “barbell” investor will likely experience losses. Under this scenario, however, the investor’s cash weighting in the barbell approach can provide the portfolio ballast; and, very importantly, it can act as an unimpaired liquidity source for opportunistic buying and/or portfolio rebalancing. In a rising rate or rising default environment, the AGG investor may have to recognize losses in order to rebalance or pursue a higher returning opportunity.
As I have discussed the barbell approach with other investors, I have gotten questions about how to benchmark this potential shift in portfolio structure. The benchmarking issue is best addressed by asking the question, “What is it that your institution wants to measure?” Hopefully, by now, your governing body and your executive leaders understand that benchmarks are not return objectives, but rather measurement tools. (I know, I know—many of your chief financial officers and non-investment experts struggle to understand this concept. Nevertheless, you can help educate these stakeholders.)
If your institution would like to measure the impact of the tactical decisions, then the right answer is to make no changes to the current benchmark. By not making a change to the benchmark, the institution will be able to measure whether or not the new portfolio positioning will add or detract value versus the “do nothing” approach. If your institution is seeking to measure the investment office’s ability to implement an agreed-upon strategy, then the benchmark should be changed to represent the new portfolio positioning. Stakeholders will be able to observe whether or not the investment team is adding value versus the new benchmark (mostly assessing the team’s manager selection decisions).
The barbell strategy may not be appropriate for every institution. I would encourage any adopters of this approach to carefully scrutinize the additional credit risk associated with the high-yield allocation. And some allocators may face stakeholders who are not comfortable with the optics of the investment office’s decision to increase the weighting to cash with cash equivalent yields near zero.
But, hopefully, with careful consideration and proper communication, the “un-coring” of your core bond portfolio can help your institution inch a little closer to its return objectives. “Un-coring” will not be enough to help investors achieve a 6% to 7% return requirement, but the opportunity to generate an additional 150-200 basis points (bps) in return without a significant increase in standard deviation might help.
Tony Waskiewicz has nearly 30 years of financial services, investment advisory, and CIO experience and most recently served as chief investment officer for Mercy Health in St. Louis.
This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Institutional Shareholder Services or its affiliates.
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OP-ED: Disaggregate Your ‘Aggregate’ Composite
Op-Ed: Using the Risk-Free Rate as a Basis to Examine Hedge Fund Costs