A Core Bond Alternative Built to Adapt

Point of View With Rick Rieder and Bob Miller

In today's world of low interest rates and massive global monetary policy initiatives, investors must be ever more aware of balancing risk and return in their fixed income portfolio. We speak with the senior portfolio managers of BlackRock's Strategic Income Opportunities Fund to discuss why traditional fixed income approaches may not work in this new world, and how an alternative approach can help investors achieve their goals.

Why should an investor consider an alternative to a traditional core bond fund?

Ultimately, an investor's allocation decision is based on two factors: risk and return. It's a balancing act that is constantly being re-set and adjusted. But for core traditional fixed income investors, that balancing act has been turned on its head as interest rates hover near historic lows yet with inflation at 1.5% but yields at only 1%, US Treasury bonds are not even keeping up.²

At the same time, the volatility that interest rates have demonstrated means that total returns for core fixed incomeinvestors is continually at risk of being wiped out. In fact, US Treasuries were more volatile than high yield bonds in 2012. Soinvestors need to be more risk-aware, to take advantage of the shifting fixed income landscape to seek yield and returns and reduce risks. Because what worked in the past may not in the future, investors should consider a different approach to their fixed income allocation.

What is your outlook for interest rates?

We believe the 10-year US Treasury will continue to drift higher over the year. A healing economy coupled with the enormous influence of accommodative central bank monetary policy is a combination we believe will eventually push interest rates higher. House prices by most measures have begun to rise as the slowly improving labor market and low housing supply push the market up. In addition, bank lending also appears to be improving as financial institutions have significantly improved their balance sheets. Each of these drivers has the potential of leading to inflationary pressures and higher interest rates at some point in the future. Taken together,we don't believe interest rates will spike, but they will likely continue to be volatile and drift higher.

What does this mean for traditional core fixed income portfolios?

It means that the traditional bond approach won't achieve investors' goals in the future. Over the course of the past 30 years, traditional core fixed income helped to preserve principal by going up when all other asset classes went down. Over this time period, traditional core fixed income offered average annual returns on par with stocks—and with lower volatility. Such performance characteristics resulted from this unique period of secularly declining interest rates and high real yields.

Today, however, the bonds purchased by the Fed for its balance sheet drive up prices and drive down yields until the income they offer stands well below the inflation rate. Such policies reflect policy choices akin to "financial repression" (i.e., explicit or indirect capping of interest rates), making the cost of holding these bonds greater than at any time in the past 30 years. In other words, investors are left with low real income and a very small buffer to protect them from the effects of rising interest rates. So investors need to find new ways to generate returns from fixed income.

How do you suggest investors find new ways to generate fixed income returns?

We believe allocating away from traditional core fixed income style that is benchmark-constrained toward unconstrained and adaptable outcome-oriented funds like Strategic Income Opportunities Fund will be a more successful approach. These funds have the ability to alter their duration (a measure of interest rate risk) profiles so as to achieve a yield in excess of duration, providing investors with the real (inflation-adjusted) income and capital preservation expected from the fixed income allocation. This adaptable fixed income approach means actively managing the balance between duration and credit risk.

What do you mean by adaptable fixed income?

Having flexibility allows a manager to find the optimal balance of exposures in the portfolio between interest rate risk (duration) and credit risk that contribute to the total fixed income risk of the portfolio. If a bond manager is bound to a benchmark, it forces the manager to replicate that index (with some limited room to "tilt" the portfolio) limiting the portfolio's potential for returns. As fixed income markets evolve from global deleveraging and government intervention, being flexible to protect against rising interest rates and invest where the opportunities lie will be crucial to a successful fixed income portfolio.

For example, the Fed's very accommodative monetary policy measures have made Treasury yields unattractive while creating an opportunity in credit sectors of the market. Liquidity provided by the Fed has allowed companies to refinance debt, push maturities further out and build cash balance levels. This will serve to keep default rates low for some time, creating an attractive opportunity in credit on a risk-adjusted basis. In addition, credit sectors provide a buffer against rates moving higher as the spread over Treasuries will likely compress as economic growth improves. As you can see in the chart, a flexible strategy like BlackRock's Strategic Income Opportunities Fund can perform better when interest rates rise than the broader fixed income market, as represented by the Barclays Aggregate Index.

Performance data quoted represents past performance and is no guarantee of future results. Investment returns and principal values may fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than that shown. Please refer to below for standardized returns for the Fund. Refer to www.blackrock.com for current month-end performance. Index performance is shown for illustrative purposes only. You cannot invest directly in an index. Barclays US Aggregate Bond Index annualized performance: 1 year, 3.77%; 5 year, 5.47%; 10 year, 5.02%.

Can you explain the limitations of a broad bond market benchmark index?

Consider today's leading fixed income benchmark, the Barclays US Aggregate Bond Index (Agg). By construction, the index replicates the debt sold in the market. Hence today it is heavily weighted toward interest-rate-sensitive securities, primarily US Treasury issues. In fact, including US Treasury debt, agency debt and agency mortgage-backed securities (MBS), the Agg is roughly 75% government or government-related securities that are extremely sensitive to the movement of interest rates.

Effectively, investors in Agg-benchmarked or similar portfolios are overweight interest rate risk at a time when it's providing the least value in 30 years. The clear risk is that even a modest rise in US Treasury yields can have a significant impact on portfolio returns.

With such wide flexibility, how do you construct portfolios?

Unlike traditional, benchmark-constrained portfolios, an adaptable strategy can invest without sector, quality, maturity or geography limitations. Guiding this flexible investment strategy is a structured and active risk budgeting process that is designed to determine and manage appropriate levels of interest rate and credit risk. Once the portfolio's overall risk level is set (measured by standard deviation⁴), we begin allocating risk across geographic and credit sectors based on macroeconomic views as well as return and price factors.

The team then performs in-depth, bottom-up analysis to select attractively valued securities across each fixed income sector of the market, such as corporate investment grade, high yield, asset-backed securities, non-US, emerging markets, etc. The portfolio managers continually assess the return they believe can be generated in each sector strategy given the changing market environment, analyzing factors such as current market yields, spreads and volatility. In this respect, the portfolio construction process is dynamic and seeks to tactically take advantage of volatility.

Finally, the portfolio managers will allocate a portion of the risk budget to non-traditional absolute return strategies to find additional sources of return. These strategies are meant to be market neutral, providing attractive excess return opportunities while seeking to limit downside. The composition between traditional/long-only strategies and absolute return strategies will be determined by the opportunity set and the underlying dynamics of the market. On a daily basis we hold a meeting with the lead sector specialists, product strategy and members of Risk and Quantitative Analysis (RQA) to review our proprietary report regarding risks and opportunities. This process aids the portfolio teams in understanding the risk drivers of the portfolio and proactively adjusting the risk-profile in relation to our views of the best investment opportunities.

As you can see in the dynamic allocation chart below, the strategy offers diverse sources of return combined with active rotation across sectors. Ultimately, this kind of approach seeks to mitigate volatility to deliver attractive risk-adjusted returns across interest rate environments.

How should an investor incorporate a flexible strategy into their portfolio?

Today's fixed income investors seeking yield with risk management similar to what traditional core portfolios offered in the past should consider re-allocating a meaningful portion of the traditional core fixed income portfolio into a actively managed, flexible strategy through a mutual fund. In contrast to the traditional core allocation (see pie charts), this approach would allow the investor to take advantage of diverse sector exposures and flexible risk-managed duration exposure to seek to achieve returns, lower volatility and downside protection.

Specific allocations will vary based on an investor's goals, risk tolerance and time horizon, and these considerations should be discussed with an experienced financial professional. Investors should note that asset allocation strategies do not assure profit and do not protect against loss. In our view, however, incorporating a professionally managed, flexible strategy into an overall fixed income portfolio can help enhance the overall success of an investor's entire portfolio.

Data represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than that shown, and assumes reinvestment of all dividends and capital gains distributions. Available in multiple share classes with different sales charges, ongoing account maintenance and distribution fees and other features. Total/net annual operating expenses as stated in this fund's most recent prospectus: Investor A shares are 1.41%/0.90%. The fund's net operating expenses exclude acquired fund fees, investment interest expenses, if any, and certain other fund expenses. BlackRock has contractually agreed to waive or reimburse certain fees and expenses until 5/1/13. Contractual waivers terminable upon 90days' notice.

¹It is not possible to invest directly in an index. Indexes are unmanaged. ²Source: US Department of Labor and Barclays. 12-month inflation is represented by the CPI Urban Consumers' % change year over year, as of 3/31/13. Yield is represented by the Barclays US Treasury Index 5-7 years, as of 3/31/13. ³Duration: expressed as a number of years, is a measure of the sensitivity of the price of a fixed income investment to a change in interest rates. ⁴Standard deviation is a measure of the dispersion of a set of data from its mean, and is used to measure an investment's historic volatility. ⁵The data is since March 2010, when the Fund's investment strategy changed. Source: BlackRock, Morningstar, Bond Hub. Traditional Core Bond Portfolio is represented by the Morningstar Intermediate-Term Bond category.

Investment involves risks. Bond values fluctuate in price so the value of your investment can go down depending on market conditions. The two main risks related to fixed income investing are interest-rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Investments in non-investment-grade debt securities (high yield or "junk" bonds) may be subject to greater market fluctuations and risk of default or loss of income and principal than securities in higher rating categories. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. Asset allocation strategies do not assure profit and do not protect against loss.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are those of the portfolio managers profiled as of April 26, 2013, and may change as subsequent conditions vary. Individual portfolio managers for BlackRock may have opinions and/or make investment decisions that, in certain respects, may not be consistent with the information contained in this report. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks.

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