Updated with correction
Managers are using more non-traditional investments in their core and core-plus fixed-income strategies in an effort to retain institutional clients that are increasingly moving to next-generation bond investments.
“Historical relationships among and within asset classes are breaking down,” Douglas M. Hodge, chief operating officer at Pacific Investment Management Co., Newport Beach, Calif., said in an e-mailed response to questions. “The relationships between investment risk and return are being redefined in the context of historically low interest rates and flat yield curves across the world's developed markets.”
Traditional fixed-income strategies “need to be diversified,” said Donald Plotsky, head of the product group at Western Asset Management Co., Pasadena, Calif. “Low yields and five-year duration — passive core — is not a formula for success.”
Added Kevin Dachille, institutional portfolio manager at Eaton Vance Corp., Boston: “It is possible to diversify core and core-plus into non-traditional sectors while remaining true to their mandates. It involves more sophisticated risk management practices, but this trend is becoming fairly universal in the industry.”
A recent white paper by Casey Quirk & Associates, Darien, Conn., said investors would pull $1 trillion from traditional fixed-income investments in the next three to five years. The white paper, whose lead author is Yariv Itah, partner at Casey Quirk, said most of those assets would be withdrawn by individual and defined contribution investors; many institutional investors have been doing so for some time. “Traditional fixed income is at risk,” Mr. Itah said. “Any firm that has more than 25% of its revenue from traditional fixed income should expect a challenge.”
The risk of those withdrawals has spurred fixed-income managers not only to boost other strategies, ranging from high-yield to longer duration bonds, but also to use elements of those in their core and core-plus approaches. Such strategies “won't go away in terms of (fixed income's) role as a safe haven,” said Mr. Plotsky. “That said, it makes sense to diversify into higher yielding, shorter-duration fixed income, but as a complement to core rather than a substitute.”
Of the total $7.4 trillion in U.S. fixed-income investments, Mr. Itah said, “the majority is invested in what we call "challenged' strategies — these are strategies that will see outflows in the foreseeable future. Adapting will require managers to change their investment philosophy, perhaps the toughest thing for a manager to change or even tweak with. Firms typically do not touch their investment philosophy, which is critical not only to their identity, but also to why investors invest with them in the first place.”