Market volatility in the second half of 2018 was cause for concern among financial professionals. In reaction, many advisors allocated to ultra-short or short duration fixed income and higher quality investments in order to wait out the turbulence. They may now be wondering – what’s next? The Natixis Portfolio Clarity® team works with hundreds of financial professionals each month on portfolio construction, and we’ve hearing the same question a lot lately: What should I be doing with my fixed income? In order to answer this, we pose a question to them: What do you want your fixed income to do?

Three strategies to consider in your bond portfolio
How advisors respond to this question helps frame our approach to what bonds they may want to consider, looking at fixed income through the lens of asset allocation and portfolio construction. Typically, we’ll get one of three responses:

What do you want your fixed income to do?

  • I’m looking for total return.
  • I’m looking for a portfolio ballast / risk reduction.
  • I’m looking for downside protection.
Each one of these answers has a unique response in terms of what utility fixed income can provide in meeting these expectations.

Seeking total return
We believe an investor looking to generate total return from their bond allocations should be focusing on what we call alpha generators – emerging market debt (both hard and local currency), high yield and the leverage loan market.

Given our expectations for modest growth over the next 12 months and inflation remaining in check, we expect the default cycle to remain benign with price differences between bonds (or spreads) remaining fairly range-bound. Against this backdrop, we prefer emerging market debt and the loan space within the alpha-generating bucket. Our Investment Committee finds emerging market assets attractive, especially with the Fed on hold for now and the expectations of modest growth acceleration in the second half of 2019. We also find the leverage loan space interesting given the yield that these assets are currently generating.

Looking for a ballast
Advisors looking for a ballast – or modest returns with an eye on limited volatility – may want to consider investment grade or mortgage-backed securities. These are higher quality bonds that still have modest room for price appreciation but tend to exhibit lower volatility, which means they have the potential to provide some form of risk reduction and sound diversification. In this space, the Investment Committee gives a slight nod to investment grade. Given our economic and inflation expectations, investment grade could earn a nice coupon with the potential for some price appreciation with spread tightening and limited volatility.

Downside protection
Many advisors looking for downside protection are often using the equity portion of their portfolio as the main driver of returns. As such, in order to provide some equity risk offset, US Treasuries tend to be the best tool, given their tendency for negative correlations to equities in a risk-off environment. Keep in mind, short duration assets have been all the rage of late, a trend we have certainly been seeing with our clients over the last few quarters. As the name suggests, short duration means limited sensitivity to interest rate moves. If rates rally sharply in a risk-off environment, short duration fixed income may not generate much return from price appreciation given that lack of interest rate sensitivity. Advisors looking for an equity offset or downside protection can consider longer duration Treasuries to fill that need.

Mission-driven fixed income
Financial professionals who are looking to reposition their fixed income allocation should remember to ask themselves: What do I want my fixed income to accomplish? Establishing clear financial goals with clients and understanding their income needs and risk tolerance can help clarify what role fixed income can play as part of a holistic investment approach.
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.

This material is intended for informational purposes only and should not be construed as a recommendation or investment advice, as the Portfolio Clarity Model Program does not take into account the investment objectives, risk tolerance, restrictions, liquidity needs or other characteristics of any one particular investor.

Alpha: A measure of the difference between a portfolio's actual returns and its expected performance, given its level of systematic market risk. A positive alpha indicates outperformance and negative alpha indicates underperformance relative to the portfolio's level of systematic risk.

Diversification does not guarantee a profit or protect against a loss.

Duration risk measures a bond's price sensitivity to interest rate changes. Bond funds and individual bonds with a longer duration (a measure of the expected life of a security) tend to be more sensitive to changes in interest rates, usually making them more volatile than securities with shorter durations.

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.

Interest rate risk is a major risk to all bondholders. As rates rise, existing bonds that offer a lower rate of return decline in value because newly issued bonds that pay higher rates are more attractive to investors.

Spreads: The yield difference between non-Treasury and Treasury securities.

Natixis Advisors, L.P. provides analysis and consulting services to investment professionals through Natixis Portfolio Clarity. The Portfolio Clarity Model Program is offered through Natixis Portfolio Clarity.

Natixis Distribution, L.P. is a limited purpose broker-dealer and the distributor of various registered investment companies for which advisory services are provided by affiliates of Natixis Investment Managers.