Flexible fixed income: A dynamic approach for uncertain markets

Strong risk-adjusted performance starts with managing drawdown risk. Flexible strategies provided favorable drawdown profiles during major credit events like the 2007–2009 financial crisis, positioning them for quicker recoveries. They also preserved value in noncredit events. In the 2022–2023 Fed rate hiking cycle, flexible strategies offered better downside protection than duration-sensitive, higher-quality categories like core and core plus (see Figure 2).

Figure 2 – Favorable drawdown profiles vs. other major fixed income categories

Dynamically managing duration and credit risk may help position flexible strategies to outperform in the future, as managers in these categories retain multiple levers to add value in different macroeconomic environments.

What’s the optimal number of strategies?

Holding too few fixed income strategies can mean there are opportunities to add complementary strategies that improve diversification. On the other hand, investing in too many strategies can often mean there are redundant exposures, making the portfolio unnecessarily complex. We analyzed trailing 10-year returns of bond strategies across a variety of categories to identify an optimal range of holdings. Our research suggests that three to seven fixed income strategies help maximize risk-adjusted returns. However, when at least one of those strategies is a flexible strategy, the math changes (see Figure 3). Holding three to five strategies with at least one flexible strategy achieved top risk-adjusted returns while maintaining a leaner lineup of holdings.

Figure 3 – Return/standard deviation by fixed income strategy count

Building the rest of the portfolio

Many investors allocate to high-quality core bond strategies to ensure an adequate portion of their portfolio retains defensive characteristics. However, many active core bond strategies struggle to differentiate from the Bloomberg US Aggregate Bond Index (the Agg). And, this index has gotten much more concentrated over the past several years, as the portion of U.S. Treasury holdings has steadily increased (see Figure 4). Rather than paying active fees for glorified Treasury exposure, consider cheaper, passive implementation of either Treasury or Agg holdings, and deploy active fees elsewhere.

Figure 4 – Bloomberg US Aggregate, Treasury Allocation

Core plus strategies typically play in a larger sandbox, providing greater differentiation from the benchmark, which increases the likelihood for more meaningful outperformance. They also complement flexible strategies by providing more reliable duration and a higher-quality tilt.

Conclusion

Now may be an opportune time to consider a more streamlined lineup of one passive Treasury or Agg strategy, one to two active core plus bond strategies, and one to two active flexible fixed income strategies. The resulting combination has higher historical risk-adjusted returns than many other fixed income portfolio constructs. This includes better downside protection amid both credit-based and rates-based volatility episodes. This implementation provides more comprehensive coverage of the fixed income universe than increasingly concentrated core-oriented portfolios. Finally, by making more efficient use of active management fees, this may better position active management across a variety of future environments.