Flexibility to invest across sectors of fixed income markets and durations can be even more advantageous in challenging times, according to Rick Raczkowski, Co-Manager of the Core Plus Bond strategy at Loomis, Sayles & Company. This is especially true when inflation spikes up and the Fed and other central banks signal a need to hike interest rates to combat it.

Here, Raczkowski delves into his team’s nimble, benchmark-aware approach, how they can tactically allocate to dial up or down risk, and where yield opportunities may exist today.

There’s a lot of bond funds out there, as we know. So what distinguishes us? I like to say that our goal is to help our clients solve their bond dilemmas. We love bonds and believe they can do a number of things. The two main things they can do are provide an offset to our clients’ equity allocation and generate yield. That’s really important, because over long periods of time, yield drives performance in a bond. But we know that there’s this tradeoff between safety and yield. There’s no free lunch. That’s the dilemma.

Our goal is to generate the best combination of safety and yield through the credit cycle. So another dilemma is where to invest. The global fixed income market is huge – so should we be invested in governments or credit? Investment grade or high yield? Domestic or international? Also, where should we be on the yield curve – short or long duration? We believe we solve that dilemma by offering a strategy that has a lot of flexibility. We can go across the fixed income universe and we can pull a lot of levers. Co-manager Peter Palfrey and I have been doing this for 20 years together. We built a team around us of some really strong individuals that help us on a day-to-day basis to leverage the deep research resources we have at Loomis Sayles to find the best sectors and securities to invest in for our clients.
We have a lot of flexibility in our Core Plus strategy, but what’s important is that we want to deliver a bond market experience for our clients, not an equity market experience. So we call this a benchmark-aware strategy, but it’s really not a benchmark tracker. We use the Bloomberg Aggregate Bond Index as the benchmark. It’s a high-quality benchmark with about 70% governments.

Philosophically, when we’re in the periods of the credit cycle where we want to be more defensive, we’re going to look more like that high-quality benchmark. But there’s going to be periods of time when we don’t think it makes sense to look like the benchmark. We think one of those times is right now. We want to start shifting from safety into yield in the strategy.
When we think about our allocations and our sectors, we put them in three buckets along a risk/return spectrum: 1. Capital preservation, risk management & liquidity bucket – made up of mostly governments, which are 70% of the benchmark and at least 20% of our strategy. 2. Additional benchmark sources of income – like investment grade corporates, sovereigns, and securitized. 3. Plus sectors – sectors that are out of the benchmark, including high yield corporates, bank loans, non-dollar foreign currencies, emerging market debt, and TIPS (Treasury inflation-protected securities). The goal is to give us potential yield advantage and additional capital appreciation opportunities.

So, if you think about coming into 2020 prior to the pandemic, we were positioned very defensively in the strategy because we thought we were late in the credit cycle. We had over half of the strategy in the governments sector, Treasuries and mortgage-backed securities. This allowed us, when we saw those big dislocations in 2020, to quickly move to take advantage of that and shift gears and move into the credit sector. Having that ballast is very important to our strategy and we manage it very carefully.

Moving to that second bucket, we overweight these sectors where we think there’s the most value. That said, the securitized sector is one area where our competitors tend to have a much higher allocation than we typically do. We’re a little bit more cautious, because this sector can be very illiquid. We believe that illiquidity is often not rewarded properly for the level of risk.

Now, the Plus sectors bucket is where we’re going to generate most of our alpha and performance over time. We will have between 0 and 20% of the strategy in high yield, again depending on where we are in the credit cycle. Another Plus sector is non-dollar foreign currency. There we can go up to 10%, but we recognize that this can add some volatility, so we want to manage this very carefully and be tactical around those positions.
I’d say bank loans. We manage this under the 20% HY allocation. They are high up in the capital structure, and have floating rates, which helps during rising rate times. While we like bank loans right now, there are periods of time when we’ve been out of bank loans completely. This illustrates how we move tactically through these plus sectors over time.
We still have a relatively bullish view on global growth, as we expect the reopening to continue globally. We do think inflation is going to remain high, much higher than it was coming into the pandemic, for a number of reasons. Even as some of the more temporary factors roll off, we have some structural factors to deal with from a wage perspective and the housing markets. But we do think overall inflation rates will come down. The Fed is going to continue to be in the picture and hiking rates this year to fight inflation. We think this will continue to put upward pressure on yield. So we are expecting yields to go higher. Also, as we expect the economy to be strong, we think default rates will remain low.

As we think about safety versus yield, we are favoring the yield part of that equation right now. Treasuries are less attractive, and we are close to the benchmark allocation in securitized agencies. We believe mortgage-backed securities could come under a little bit of pressure as the balance sheet starts to roll off from the Fed, but we still think that’s a good high-quality source of yield. In investment grade corporates, we are finding more attractive opportunities outside the US and in the triple-B credit quality arena. And again, we still think bank loans and high yield corporates are offering good opportunity, with relatively low levels of default risk expected. Lastly, we think we can capture incremental yield in some non-dollar exposure, in places like Mexico and Uruguay.
We keep duration within a band of 0 to 2 years relative to the benchmark. Right now we favor a shorter duration at around one-and-a-half years. We think this may help with positioning defensively against future interest rate increases.
All investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.

Fixed income securities may carry one or more of the following risks: credit, interest rate (as interest rates rise bond prices usually fall), inflation and liquidity.

Mortgage-Related and Asset-Backed Securities Risk: Mortgage-related and asset-backed securities are subject to the risks of the mortgages and assets underlying the securities. Other related risks include prepayment risk, which is the risk that the securities may be prepaid, potentially resulting in the reinvestment of the prepaid amounts into securities with lower yields.

Below Investment Grade Securities Risk: Below investment grade fixed income securities may be subject to greater risks (including the risk of default) than other fixed income securities.

Foreign and Emerging Market Securities Risk: Foreign and emerging market securities may be subject to greater political, economic, environmental, credit, currency and information risks. Foreign securities may be subject to higher volatility than US securities, due to varying degrees of regulation and limited liquidity. These risks are magnified in emerging markets.

Currency Risk: Currency exchange rates between the US dollar and foreign currencies may cause the value of the fund's investments to decline.

Inflation Protected Securities/TIPS Risk: Inflation protected securities move with the rate of inflation and carry the risk that in deflationary conditions (when inflation is negative) the value of the bond may decrease.

Bond duration measures how much bond prices could change if interest rates fluctuate.

A plus strategy adds additional fixed income sectors like high yield bonds, emerging market bonds, and floating rate bank loans in an attempt to improve income or return potential in exchange for a higher risk profile.

This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed are as of January 19, 2022 and may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted. Actual results may vary.

The Bloomberg U.S. Aggregate Bond Index is a broad-based index that covers the U.S.-dollar-denominated, investment-grade, fixed-rate, taxable bond market of SEC-registered securities. The index includes bonds from the Treasury, government-related, corporate, mortgage-backed securities, asset-backed securities, and collateralized mortgage-backed securities sectors.

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