As the world grapples with an uncertain growth and global interest rate outlook, active and unconstrained strategies are more important than ever for fixed-income investors, according to Western Asset Management.

In a new white paper—“Defending the Defensive: Protecting Your Fixed-Income Portfolio in a Low-Yield World”—Western Asset, one of the world’s largest fixed-income managers, urges investment advisers to rethink the traditional “index-hugging” approach to defensive allocations.

Anthony Kirkham, Head of Melbourne Operations and Investment Management at Western Asset, said the following about the white paper, which was written by Western Asset’s Head of London Operations Michael Zelouf: “Central bank rate cuts, quantitative easing, a subdued global recovery and low inflation have left global bond yields at near-record lows. Against this background, a more flexible, active approach can provide the latitude needed to best position this ‘defensive’ asset class, which acts as a ballast to risk assets such as equities.”

Without the obligation to track the benchmark, long-only active strategies, and unconstrained strategies, have the potential to decouple a portfolio from prevailing market forces and offer alpha returns.

Passive strategy returns are entirely attributed to beta factors (general market movements); traditional active strategies have an attribution of around 75% to beta factors and 25% to alpha factors (manager skill driven); while unconstrained bond strategies increase this attribution to alpha to over 50%—delivering a low correlation to equities and traditional bond sectors.

“Unconstrained fixed-income strategies seek to achieve their objectives during both bullish and bearish bond environments, by rotating between government and spread sectors as well as managing duration, yield curve and volatility,” Mr. Kirkham said.

“Unconstrained is all about being nimble, responding to macroeconomic forces and seizing opportunities. It’s not something fixed-income has always been known for, but unconstrained funds are now becoming an important part of the mix because of their responsiveness,” said Mr. Kirkham.

Western Asset’s paper demonstrates how passive, long-only active and unconstrained approaches play out in three economic scenarios.

The base case is essentially what’s happening now: moderate growth and inflation, with a “low and slow” approach to interest rate rises.
A primary risk scenario that sees inflation rise in a belated respond to monetary stimulus. Bond prices fall sharply as markets price in higher interest rates, although over time, credit spreads narrow, because better growth supports credit fundamentals.
The third, less likely but more serious scenario, is a secondary “tail” risk: a deflationary stall in growth, where China and emerging markets drag down developed markets. Government bonds benefit but credit and other spread sectors perform poorly.
Under the primary and secondary scenarios, where bond investors are likely to focus on downside risks, active management, global and unconstrained strategies are likely to perform better in these environments.

“Ultimately, different strategies come to the fore depending on the macro environment,” Mr. Kirkham said.

“The take-out for investors is that there is no perfect fixed-income strategy for all weather—the key is to consider your investment outlook and the chief risks you see to your base case. Additionally, think about the factors driving the allocation to fixed-income in the first place.

“The appropriate mix of bond strategies you employ in a portfolio will be influenced by whether you are prioritising capital preservation, income, capital gain or any other number of factors.

“Overall, unconstrained and long-only active management solutions can have a clear role to play in an uncertain world. Given the level of manager skill required, however, investors must evaluate the manager’s resources, process and track record,” Mr. Kirkham said.

Source: Western Asset Management

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