Casting Off Constraints

Today's uncertain economy and fixed income marketplace can be challenging for investors to navigate. Against this backdrop, BlackRock's fixed income experts discuss why now is an ideal time to consider a flexible, unconstrained fixed income strategy.

• With interest rates at historic lows and their future direction unclear, navigating the current market environment has become difficult for fixed income investors.
• Increasing uncertainty about the direction of the global economy requires investors to consider an alternative to traditional fixed income investment strategies.
• A flexible approach offers investors an opportunity to enhance yield and total return while seeking to mitigate the risks associated with a volatile interest rate and credit environment.
• Flexible fixed income strategies that seek to capitalize on market opportunities, while also managing duration and credit risk, should be a cornerstone in a diversified fixed income portfolio.

Q. Traditional bond portfolios have performed well but with rates now at historic lows, investors are concerned they won't in the future. How can investors continue to reap returns while also protecting against downside risks?

It's a great question, particularly given the economic uncertainty and volatility across financial markets. Fixed income investors have been in a golden age for years now, with a secular bull market decline in interest rates and corresponding rally in bond prices. In fact, since the 1980s, yields on 10-year US Treasury securities have fallen dramatically, from over 15% to less than 3%, offering equity-like returns with only a third of the volatility (see chart below). But with interest rates at historic lows, continuing uncertainty about the economy and credit, and higher rates inevitably at some point in the future, there's a sense that the party may be over.

It is in this kind of challenging environment that investors can benefit from shifting some of their traditional benchmarked fixed income allocations to a flexible, unconstrained approach. Such a strategy can dynamically invest across the broad fixed income universe within a risk-controlled framework that allows investors to balance being opportunistic with managing for risk.

Q. How is a flexible strategy different from a traditional bond strategy?

The difference is that most traditional bond portfolios are managed and measured against a benchmark index. Why is this so important? Because a benchmark by its nature reflects specific allocations across fixed income sectors. If a bond manager is compelled to replicate that index, it could limit the portfolio's potential for returns.

Casting off narrow benchmark constraints allows an investor to maintain a more advantageous mix of interest rate risk and credit risk, as well as to capitalize on the most compelling opportunities around the globe and across all fixed income sectors. When investing in a diversified, unconstrained portfolio, the portfolio manager also is equipped to rapidly and effectively manage key fixed income risks, such as interest rate and credit exposures. At the same time, professional managers can assume investment positions with greater conviction by using a broader range of tools to seek returns in challenging markets.

Q. What are the limitations of a broad bond market benchmark index?

A perfect example to show the limitations of a benchmark index is today's leading fixed income benchmark, the Barclays Capital US Aggregate Index (Agg). It has been the benchmark of choice since the late 1970s and throughout the bond bull market. Currently,however, it is also 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. Under this construction, about 80% of the risk in the index is driven by interest rates (as measured by duration). In the current volatile interest rate environment, fixed income investors should think about balancing the duration portion of their portfolio with credit-sensitive securities, to mitigate interest rate risk and to gain higher yield.

Indeed, investors should understand that duration is a measure of a bond's sensitivity to a change in interest rates. In the event rates rise, the price of a bond with greater duration will suffer more than a bond with lower duration. When it comes to a portfolio of bonds, duration can differ from the portfolio's average maturity. The chart to the right illustrates how higher-duration bonds are impacted more negatively than lower-duration bonds.

So with rates at historic lows, investors are not being compensated for the amount of duration risk they're assuming. Incorporating a greater allocation to credit product (or spread sectors, those with a lower correlation to Treasuries) should help a portfolio adapt to transitions in the economy and the interest rate backdrop. Effectively, investors in Agg-benchmarked portfolios are overweight interest rate risk at a time when it's providing the least value in 30 years. With such a heavy weighting to government securities, investors are inherently underweight attractive opportunities in credit, including corporate and securitized debt. At the same time, while the opportunity in credit is great, the fixed income markets have grown increasingly complex and diverse, requiring a multi-sector and active approach to managing credit exposure.

Q. How does a flexible portfolio manager protect the portfolio from volatile interest rates while simultaneously seeking to enhance returns?

It's the right question, since we expect rates will be volatile and may eventually rise from today's historically low levels. While longer duration strategies (those with high degrees of sensitivity to interest rate movements) outperformed over the last 30 years as rates generally trended lower, the current environment requires a more credit-sensitive approach, with lower duration to mute interest rate risk. In fact, we believe that 1 to 4 years of duration is the best range to be in from a risk/return perspective. In extreme market scenarios, we could envision going as short as -2 years or as long as +7 years (see chart on next page).

For example, with the shorter business cycles the economy has been experiencing, fixed income investors need to take a more active approach in appropriately managing for duration and credit risk. During 2010, a year characterized by a slow growth economy supported by two rounds of highly accommodative monetary policy, investors were best served by extending duration and maintaining an overweight to spread sectors. This year, however, while economic data remains weak and supportive government policies have rolled off, the much lower levels of interest rates and the volatility of risk assets, investors are best served by dynamically managing both interest rate and credit risk.

But perhaps the best defense against the risk of volatile or rising rates is to invest with a manager who will not just overweight one sector, but can do the careful analysis to identify the strongest areas of the market. A professional portfolio manager with a dynamic and flexible mandate, rather than a "core bond" approach, can utilize the range of tools necessary to navigate a fixed income marketplace wherein selectivity is increasingly important to investment success. The manager can adjust sector allocations in an effort to achieve above-market returns, while also seeking to maintain downside protection.

Q. With such wide flexibility, how do you make decisions about which securities to invest in?

That is one of the key challenges of managing a flexible, unconstrained portfolio. We are looking across the spectrum of fixed income sectors to determine: where are the investments with real upside, and where is the fresh investment idea? Thereare a couple of things we do to help us identify these.

Initially, we establish a budget for the amount of risk (measured by standard deviation) that we will take across the portfolio, based on the current environment (see chart at right). Once that overall risk level is set, we begin allocating risk between duration and credit, as well as across each fixed income sector of the market, such as corporate investment grade, high yield, asset-backed securities, etc. So in making investment decisions, we weigh each investment opportunity by asking: Is the balance between duration and credit risk optimal for this market? Is this the best risk/reward decision? And, how does this investment impact the overall risk budget?

Are the manager's size and scale advantages in fixed income?

Absolutely. In fact, it is an important part of the investment process. With the breadth of talent and specialization at BlackRock, we are able to take advantage of specialists who focus on very specific sectors or geographies within the broad fixed income universe. With the wide range of securities available globally, many of which are quite complex, having that specialist knowledge of a particular sector or local geography is invaluable. For our flexible fixed income portfolios, we include representatives from each sector as part of the portfolio review team in an effort to identify the best ideas. It is this culture of idea sharing and communication between fixed income teams that brings some of the very best investment ideas to the fore.

In addition, our scale gives us tremendous access to markets and an important information advantage. That information allows us to take advantage of less liquid or less accessible markets. We've actually created an origination function to go out and source compelling assets from around the world, which is a competitive advantage as we seek returns. Furthermore, the power of BlackRock's technology platform allows the portfolio managers to isolate and monitor daily the risk and return of particular trades or sectors.

Q. It seems that having all of this flexibility would make this approach more risky. Is that true?

Actually, the opposite is true. A flexible strategy doesn't necessarily take on any more risk than another fixed income fund. In fact, by using additional tools to go outside the limitations of a benchmark, the manager can mitigate some risk that may come with being tied to a benchmark. And in a fixed income environment where rates are volatile, the manager can defend against a rise more effectively than a traditional benchmarked portfolio, potentially having a lower-risk/higher-return profile than the traditional core bond portfolio. Furthermore, the risk budgeting process that we use, wherein we apply a risk ceiling, effectively limits the volatility the portfolio will be exposed to.

Q. Are all unconstrained funds managed the same way?

Not at all. It's clear there are a fair number of managers now using a "flexible" strategy, but those strategies are not all the same nor are they created equally. The range of approaches to fixed income market risks runs the gamut, from conservative "always risk-off" (low market risk, as measured by beta) approaches, to aggressive "always risk-on" (high market risk) approaches.Each of these approaches has merits for certain investors, but also distinct weaknesses, such as low return or high volatility, for example. We believe the optimal approach moves between risk-on to risk-off in an effort to capitalize on opportunities for yield and total return, while also protecting against the downside (see chart below). The chart shows that the risk-off approach has low market risk exposure and the aggressive approach has high market risk exposure, with the optimal approach balancing the extremes.

Q. How should investors incorporate a flexible strategy into their portfolios?

Given the challenges of navigating today's fixed income environment, we recommend investors allocate a meaningful portion of their traditional core fixed income portfolio to a professionally managed, flexible strategy through a mutual fund. This would allow the investor to maintain an allocation to traditional core bonds, while allowing the portfolio manager to take advantage of the credit and interest rate environment to both achieve returns and protect on the downside.

Outside of that core position, advisors can help clients add tactical positions in order to increase their portfolio's diversification and income potential. Specific allocations for each particular asset will vary based on an investor's goals, risk tolerance and time horizon, and these considerations should be discussed with an experienced financial professional. 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.