Investors are forced to look elsewhere for yield

The 2008 financial crisis prompted a major shift in the composition of the main fixed-income index, the Barclays Capital Aggregate Bond Index, forcing investors to review their allocations.

Increased government issuance of Treasuries and government support have created more concentrated exposures than prior to the credit crisis.

U.S. Treasuries in the Barclays Capital Aggregate Index are above 30%, a historical high over the past decade, according to David Zielinski, Fixed Income Product Manager at Manulife Asset Management.

The fast pace at which the government has been issuing Treasuries to fund deficits in the U.S. and fiscal policy as well as numerous takeovers by the government during the credit crisis -- including that of Fannie Mae and Freddie Mac -- accelerated the exposure to government-held bonds in the Aggregate. Meanwhile, the growth of government debt has far outpaced the growth rate of other sectors of the bond market, including the corporate bond market. "The index became very concentrated in government issuance and isn't as diversified as it was just a few years ago," Zielinski added.

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"The market in the U.S. has changed dramatically," said Colleen Denzler, Senior Vice President and Head of Fixed Income Strategy at Janus Capital Group. "The main index isn't representing investors' risk tolerances. Agencies and mortgages are all behaving like treasuries due to conservatorship and low spreads."

Government securities represent the lowest-yielding sector in the fixed income market and as a result total returns on fixed income as defined by the Aggregate could be negative, especially if interest rates were to rise. This concentration has prompted money managers to take advantage of a more unconstrained management approach and to seek risk and yield elsewhere. For Denzler, there are two choices to diversify: investment-grade corporate credit or commercial mortgage-backed securities. She added that high-grade corporates represent roughly 24% of the Aggregate and CMBS represent roughly 4% of the index.

Other money managers such as Manulife and Cutwater Asset Management reckon opportunities are also multiplying abroad, particularly in emerging markets.

With its Global Multi-Sector Fixed Income Strategy, which comprises $10 billion in assets under management, Manulife has the ability to invest across the globe in sovereign and corporate bonds from the developed world as well as from emerging markets, including Singapore, Korea, Malaysia, Indonesia and the Philippines. Manulife emphasizes the importance for managers to have increased flexibility to seek out fixed income investment opportunities like those in emerging markets.

Cutwater aims to take advantage of the high concentration in non-U.S. bonds in the Aggregate through its Global Strategic Income strategy. The share of non-U.S. bonds in the Aggregate has significantly increased in the past couple of decades. This shift is due to a significant growth in emerging markets, particularly in China and India. "Investors should take advantage of this secular shift taking place," said Gautam Khanna, Senior Portfolio Manager for High Yield and Global strategies at Cutwater.

But some managers believe that this new challenge of having a great concentration of government-held bonds in indexes such as the Aggregate can be managed with other fixed-income products that are becoming increasingly popular.

"There is currently a lot of discussion around benchmarks, given the changing composition over the past few years," said Steven Huber, Portfolio Manager at T. Rowe Price. "We believe the choice of benchmarks is a key metric in setting investment policy, and we strive to add value over whatever benchmark is chosen. Fortunately, a broader set of tools available today in investment markets, including swaps and derivatives, facilitates managing to custom benchmarks or less benchmark-centric mandates."