A traditional core bond allocation provides ballast for a portfolio during periods of uncertainty. Ordinarily, that's because of bonds' negative correlation to equities. Correlations tend to increase as investors move down the quality ladder, reducing the effectiveness of bonds' ability to dampen volatility in investors' overall portfolios.
In recent years, we've seen investors drift away from core fixed income in a low-yield environment. During the global financial crisis, the Federal Reserve lowered the federal funds rate to an all-time low of zero to 0.25%. That pushed some investors to venture further out on the risk spectrum, potentially assuming greater liquidity risk in exchange for greater yield. Private credit and leveraged loans became two popular landing spots, as evidenced by leveraged loans' $503 billion and $436 billion in issuance in 2017 and 2018, respectively.
Then, when the Fed embarked on its tightening campaign in late 2015, some investors limited their exposure to longer-term bonds. Short-duration mutual fund flows, which had been negative, reversed course in 2016.
The result is that investors may have opened their portfolios to more risk than they realize, flocking from core bonds to higher yielding, but less liquid securities. Now, as rate uncertainty and market volatility return, investors would be wise to revisit their core fixed-income allocations to ensure that their portfolios are appropriately diversified in a tougher environment.