HomeMortgageFoley: Fixed income investing has evolved. A guide to portfolio optimization

Foley: Fixed income investing has evolved. A guide to portfolio optimization

  • A duration target for the bond portfolio — to produce income and ideally provide an offset when equities sell off.
  • A separate and distinct choice of credit exposure in the bond portfolio — also to provide income and an offset, with a higher yield and distinct drivers, often via a credit-focused fund.
  • Real estate (equity) — a real asset, expected to generate steady long term capital appreciation with low correlation to other asset classes.
  • Infrastructure (equity) — similar to real estate, with its own drivers and diversification possibilities, also expected to keep up with rising inflation.
  • Mortgages — similar to a bond, often with a higher yield, a mortgage is a loan, secured by an asset, paying regular interest payments.
  • Private debt — less liquid loans to individuals or companies, often at a premium yield, which may be secured by an asset or pledge.
  • High yield exposure (potentially) — riskier debt often producing an incremental yield and exposure to a unique set of companies, with a different price relationship to underlying rates than investment grade credit.

To clarify the division between the first two bullet points about bonds above, investors are now choosing the optimal duration for their bond portfolio and the best way to gain that exposure. At the same time, they are separately choosing the optimal credit fund for the bond portfolio. Further, credit funds have proven to be a valuable source of uncorrelated return. Investors have recognized that the two exposures within bonds are distinct and that duration and credit investing are discrete skill sets. Credit investing managers, who eliminate rate exposure, have evolved in the past ten years and many credit funds have outperformed traditional bond funds, with higher expected returns looking forward.

A combination of these asset classes should still make up roughly 40% of the total portfolio depending on your choices and risk tolerance, but as you can surmise, it looks and acts a lot different than the traditional fixed income bucket. Many of these asset classes performed very well while bonds stumbled in the past few years, and they are essential parts of an optimal portfolio going forward.

For example, we have recently seen credit outperform duration in this cycle and expect that will continue. We have seen most real estate valuations hold up better than rates or public equities, other than in a few isolated incidents. Conservative mortgage funds have been solid performers, and many mortgage fund yields are now reflecting the higher interest rate levels. Further, high yield has held in better than some expected and while private debt may be subject to further revaluation due to higher rates it has performed well too.

Many of these Fixed Income bucket exposures, save for interest rate exposure more recently, have been stable investments and have proven the ability to generate valuable return for the portfolio, handily outperforming the equity bucket in this recent cycle and potentially decreasing the need for risk within the equity portfolio.

This refreshed portfolio introduces several diversifying strategies that improve total portfolio risk metrics. Some investors monitor these asset classes in a separate “Alts” bucket along with other growth-oriented exposures, but I find it simpler to break them into the traditional 60-growth / 40-safety-income-buffer portfolio design, as outlined above. Further, considering all investment options on an expected risk-adjusted return basis, and not only an expected absolute return basis is highly likely to generate better returns over the medium and longer time periods.

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