An argument against constraint
Why it’s time to rethink the traditional fixed-income portfolio
BY Kent Wosepka | April 23, 2014
Central bank intervention has been the dominant theme in fixed-income markets over the last five years. Bond purchases and other measures by central banks in the United States, Japan, Europe and the United Kingdom created a liquidity “super cycle” that drove interest rates lower across the globe.
Unfortunately, traditional fixed-income allocations tend to be heavily concentrated in government and government-related bonds, which are the sectors where central bank intervention has had the biggest effect on yields. As a result, many investors are heavily exposed to the downside risks of rising interest rates and are also being poorly compensated for that risk due to low yields.
With the American economy showing signs of recovery, the U.S. Federal Reserve is likely to begin reducing its intervention in the fixed-income market sooner rather than later. As the Fed slows the pace of its asset purchases, interest rates are likely to normalize, moving higher over a prolonged period.
Against this backdrop, investors are increasingly re-evaluating the traditional bond allocation and moving into strategies that are more flexible and less constrained by traditional benchmark considerations. These so-called “unconstrained” approaches provide a much broader opportunity set, including all global fixed-income markets and sectors. On the other hand, unlike traditional approaches, unconstrained approaches have no embedded interest-rate risk. In an unconstrained approach, interest-rate risk is one of many risk factors that can be employed at any given time.
Unconstrained approaches are an attractive option for investors seeking the traditional benefits of a bond allocation without the interest-rate risk that is embedded in traditional approaches. Fixed-income markets are diverse, providing the opportunity to rotate among sectors as the economic and market environment changes.
Unconstrained approaches effectively outsource this sector rotation to a team of professionals. They also allow the portfolio to be more opportunistic and diversified in the pursuit of return. For example, after the Fed began to indicate that it would eventually reduce its asset purchases, emerging market debt experienced heavy selling. This created a classic situation of babies being thrown out with the bath water, as fundamentally attractive bonds were sold off amid the broader sell-off.
An unconstrained approach can instead use these opportunities to tactically add risk when broad-selling by others creates an opportunity. Unconstrained portfolios that employ a global approach are also better equipped to implement strategies focused on relative value, which can be an important source of return in situations where few sectors offer attractive directional risk.
Kent Wosepka is global head of corporate credit, Goldman Sachs Asset Management