What’s in Your Fixed Income Allocations?

Non-profit investors allocate to fixed income to accomplish a variety of objectives. Those objectives include diversifying equity risk, enhancing return, generating income, and/or providing liquidity. It is important to be informed about the allocation within your fixed income portfolio and the potential impact a market downturn could have on it.

Read the full article below for more information on fixed income allocations.

Core vs. Core Plus

The base of a fixed income allocation is often the core bond manager. Unfortunately, the term “core bond” is often used to describe everything from pure investment-grade managers that hew closely to the Bloomberg Barclays Aggregate U.S. Bond Index (the Aggregate) to aggressive core plus managers that invest in high-yield bonds, bank loans, foreign currencies, and emerging market debt.

A first step to understanding these mandates is to understand their benchmark. The Aggregate measures the performance of the U.S. dollar-denominated, investment-grade, fixed-rate taxable bond market. There is a lot to unpack in those words—what do they mean? In general, the Aggregate is defined as including three broad sectors: U.S. government bonds (45% of the index), corporate bonds (25%), and securitized bonds (30%). While that may seem comprehensive, the majority of the U.S. taxable fixed income market is not, in fact, in the Aggregate. The Aggregate excludes any issue that is floating rate, inflation-protected, non-investment-grade or unrated, convertible, or has less than a year to maturity. Additionally, included bonds are subject to issuance size limits that vary by the type of bond. The issuance size limits most dramatically impact the securitized credit market, which contains more small issues than the government and corporate sectors.

Core and core plus managers have important similarities and differences. An important similarity is the benchmark—the majority of managers in each category benchmark themselves to the Aggregate. An important difference is how fixed income managers invest relative to the Aggregate. Their investment approach may differ significantly across sector rotation, security selection, and/or duration management, as well as in how aggressive their alpha and tracking error targets are. The typical gross benchmark excess return target for core managers is 50 to 100 basis points (bps), while tracking error target is generally around 100 bps. For core plus, the estimates are 100 to 200 bps and 200 bps, respectively.*

Portfolio Tilts and Out-of-Benchmark Exposures

The types of trades managers use also can vary dramatically both across and within core and core plus mandates. In general, core and core plus managers approach the non-benchmark sectors differently. An erroneous assumption is that when managers go outside the Aggregate, they are adding risk to the portfolio. However, a more accurate risk assessment is evaluating the specific securities being purchased and excluded.

_{*Based on industry norms}

For example, adding Treasury inflation-protected securities (TIPS) increases tracking error, because they are non-benchmark securities. But TIPS have less risk than equivalent-duration nominal Treasuries, since they can eliminate the risk of unexpected inflation. While non-benchmark AAA securitized credit may add spread and volatility risk over Treasuries, the trade should reduce risk if the AAA securities replace BBB corporate credit. Both core and core plus managers implement these lower-risk portfolio tilts, but they are more common for core managers.

With a higher tracking error allowance, core plus managers typically search for alpha more aggressively. A partial list of non-benchmark securities for core plus mandates can include high-yield bonds, bank loans, non-agency mortgage-backed securities, lower-rated asset-backed securities, emerging market debt, foreign currencies, and/or credit risk transfer securities from Fannie Mae and/or Freddie Mac. Core plus managers are also more aggressive within the benchmark and are more opportunistic in making duration and yield curve trades.

In addition to the differences between core and core plus, within each of those categories managers can run very different portfolios. Certain managers focus on a specific subset of the bond market—for example, securitized, corporate, and macro positioning—based on their expertise. In the following two charts, we illustrate the dispersion in both Aon’s buy-rated core and core plus universes (blue diamonds) and the broader fixed income universes (black dots) on a risk-return basis. Even among managers that we feel are appropriate to place in client portfolios (blue diamonds), there can be meaningfully different levels of risk.

Chart 1: Core Fixed Income Universe (Gross Return vs. Risk) Annualized Over 10 Years

_{Source: eVestment as of 6.30.2019. Past performance is not indicative of future results. Blue diamonds represent Aon’s buy-rated Core Fixed Income Managers. Black dots represent managers included in the eVestment Core Fixed Income universe. eVestment team members use several key criteria such style and performance analysis tools and the product’s investment strategy narratives when determining a peer universe.}

Chart 2: Core Plus Fixed Income Universe (Gross Return vs. Risk) Annualized Over 10 Years

_{Source: eVestment as of 6.30.2019.}

_{Past performance is not indicative of future results. . Blue diamonds represent Aon’s buy-rated Core Plus Fixed Income managers. Black dots represent managers included in the eVestment Core Plus Fixed Income universe. eVestment team members use several key criteria such style and performance analysis tools and the product’s investment strategy narratives when determining a peer universe.}

Historical Risk and Return and Call to Action

While return and tracking error targets tell investors a lot about how managers approach risk and return, they are, of course, just targets. How do the targets match up to actual performance numbers? As noted in Table 1, over the last 10 years (through June 30, 2019), the Aggregate has returned 3.90%. According to eVestment, the median core bond manager has returned 4.59% gross of fees, while the median core plus manager has returned 5.58% on the same basis. This largely matches up with the mid-point excess return expectations for each category.

Table 1

_{*Gross of fee returns; annualized 10-year period ending June 30, 2019}

_{Source: eVestment}

_{Past Performance is no guarantee of future results. Indices cannot be invested in directly. Unmanaged index returns assume reinvestment of any and all distributions and do not reflect our fees and expenses. The Bloomberg Barclays US Aggregate Bond Index is a broad base bond market index representing intermediate term investment grade bonds traded in United States. eVestment team members use several key criteria such style and performance analysis tools and the product’s investment strategy narratives when determining a peer universe.}

Because of the more aggressive nature of core plus managers, we expect them to underperform the Aggregate and core strategies when equities decline strongly. A good example of this is the fourth quarter of 2018, which saw a significant selloff in riskier assets. During this period, the median core plus manager trailed the median core manager, and both trailed the Aggregate. However, in the first quarter of 2019, which saw a meaningful rally in risk markets, those performance numbers are reversed—with core plus leading the pack. Performance followed the same pattern during the financial crisis.

Overall, volatility is generally higher for core plus managers (see Table 2). The exposure to riskier assets, including lower-quality corporate and securitized credit, is the primary reason for this performance pattern.

Table 2

_{*Gross of fee returns; financial crisis defined as October 2007–March 2009}

_{Source:eVestment}

For non-profit investors, where to allocate and implement on the core/core plus spectrum requires thoughtful consideration. We believe that fixed income is an attractive segment for active management; active managers can profit from illiquidity premiums and profit additionally from taking the other side of market movements driven by investors motivated by factors other than fundamental value (e.g., hedging liabilities and regulatory requirements).

As a result, we tend to favor core plus mandates for investors who can tolerate their tracking error and liquidity. For other investors, core mandates can also be attractive. If your non-profit has not reviewed its fixed income strategy recently, now would be a great time to do so.

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