U.S. Treasuries are as safe as being in your mother’s arms, but for the most part their yields stink. High-yield bonds can juice returns, but that potentially adds volatility.
Yet a prudent investment portfolio should include fixed income because the asset class (for the most part) is negatively correlated to equities and equities do sell off now and again, said Priscilla Hancock, managing director and head of the fixed-income insights team at JP Morgan Asset Management, who spoke during a session at this week’s Inside ETFs conference in Hollywood, Fla.
She noted that diversification is key to boosting the odds of creating a successful fixed-income portfolio that marries non-correlation with the ability to generate sufficient income. In that vein, she flashed a chart representing a fixed-income triangle, which she said is a framework for fixed-income portfolio construction. She described it as a simplified model of what institutional investors call risk parity where the aim is to balance portfolio risk—i.e., when risks are low they can take more risk and vice versa.
The triangle contains three parts, and it starts with the base consisting of core fixed-income holdings that aim to decrease volatility and provide diversification to equities. This incorporates short- to intermediate-term high-quality fixed income, as well as diversified and sector-specific strategies.
“But there are times when that doesn’t yield enough, and almost always our clients want to add more risk to get yield from their [fixed-income] portfolio,” Hancock said. “Typically, to do that you take the core portfolio and slap on high yield.”
High-yield fixed income occupies the top part of the fixed-income triangle, called the “extended sectors” category, along with investment vehicles such as bank loans, long-duration bonds and fixed income in the emerging markets and international/global spheres. These sectors seek income and/or total return.
“The problem with high yield is it has high correlation to equities and high volatility,” Hancock said.
That brought her to the third part of her model known as the core complement category, which occupies the midsection of the fixed-income triangle. This involves absolute return, along with inflation hedged and ultra-short strategies, and its purpose is to reduce volatility to a more comfortable level.
“There are three ways to do that,” Hancock explained. “One is by adding an absolute-return portion, where the goal is to be positive in all market environments. By definition that’s not correlated to rates, and as a result you’re not correlated to your core. So with two uncorrelated portfolios merged together, you’ll have lower volatility.”
The second way to do it is to add an inflation hedge, such as Treasury inflation-protected securities, or TIPS.
“When rates are rising, the core typically is underperforming,” Hancock said. “If you have an inflation hedge you’re getting a positive return to help offset that, helping to bring down your volatility.”