Expand Your Core: Constructing a Bond Portfolio to Prosper in Changing Environments
From: Ocean Park Asset Management
Executive Summary:
• Just as the S&P 500 Index is the “go-to” benchmark for U.S. stocks, the Bloomberg Barclays U.S. Aggregate Bond Index (often called the “Agg”) acts as the go-to index for core U.S. bonds.
• U.S. 10-year Treasury rates have fallen for the past 40 years from a high of over 15% to 1.3% as of August 2021. While interest rates are currently very low, we have seen an improvement from 2020, when the 10-year Treasury rate dipped below 1% before rebounding.
• The multi-decade decline in interest rates boosted the returns of both government bonds and core fixed income indices such as the Agg.
• Low interest rates for core fixed asset classes have two effects on investors. First, they increase bonds’ duration, raising their sensitivity to changing interest rates. Second, low interest rates reduce investors’ income from core bonds, lowering the potential for future returns.
• And as we saw early in 2021, “safe” government and corporate bonds can have negative returns in periods of rising rates.
• The good news is that the Agg isn’t the only option for fixed income investors. The Agg is quite narrow in its scope, representing less than half the U.S. fixed income market while completely excluding non-U.S. fixed income markets.
• Some of the major fixed income asset classes left out of the Agg include high yield corporate bonds, high yield municipal bonds, preferred stocks, floating rate loans, developed and emerging market debt, and more.
• Investors who “Expand their Core” to include other fixed income asset classes may be able to increase their expected returns, while also increasing risks.
• Low interest rates and high bond duration presents challenges to fixed income investors. In our firm’s view, the key to successfully navigating the current environment is to expand beyond the typical core asset classes, while paying attention to and managing risk.
