Commentary: It's time to strengthen your core

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.

Diversification is important. A key attribute of core bonds is their negative correlation to equities, which means that they typically provide some stability when stocks are under pressure. Over the last five years, the Bloomberg Barclays U.S. Aggregate Bond index's correlation to equities has been -0.05.

As investors stray from a core bond anchor, that cushion becomes less effective. Riskier investments tend to be increasingly correlated with equities. For example, in December, the S&P 500, which had daily moves of at least 1% 12 times that month, fell 9%. The more risky (and more correlated) Bloomberg Barclays US Corporate High Yield index lost 2%, while the aggregate index gained 1.8%.

While some investors abandoned core bonds in their post-crisis reach for yield, core bonds may also have fallen out of favor during the most recent Fed tightening cycle. So far, 2019 has shown that interest rates are unpredictable. The good news is that bond investors can benefit in the long run regardless of the future direction of rates.

Investors are typically well-versed in the mark-to-market impact of rising rates. When bond yields increase, bond prices fall. But some investors may not realize that higher yields also result in higher future portfolio income. Over the course of a typical rate cycle, an investment-grade fixed-income portfolio will generate positive returns if the investor holds steady. Virtually no other asset class has this self-correcting price/income dynamic. As such, most investors should maintain a healthy allocation to core fixed income, regardless of their interest rate outlook.

A core fixed-income allocation may serve as both an equity market hedge and also as a source of income. In lower-rate environments, some investors may overlook core bonds because of their less attractive yield profiles relative to riskier assets. But not all core bonds are created equal.

The aggregate index, which typically serves as the benchmark for investors' core bond allocation, is heavily weighted toward Treasuries (39.4%) and AAA-rated securities (72%). As such, the general view is that the index is an inadequate representation of the bond universe.

For investors looking to boost yields, it may make sense to turn to active management. Robust, bottom-up security selection can help uncover opportunities that may augment a core bond portfolio's total return. This is a distinct advantage of actively managed portfolios, which tend to be more nimble, dynamic and diverse, and better prepared to take what the market gives them.

The market's recent bouts of volatility have been in sharp contrast to what investors' experience in recent years have come to know. Now is the time for cooler heads to prevail.

A balanced approach to fixed income, which includes a core bond allocation, may be prudent during times of uncertainty. For those investors who have used short-duration bond funds to play defense, it may be time to play some basic offense. And for investors who have traveled down the risk spectrum, it may be time for a credit and liquidity upgrade.

For the last five years, the aggregate index's average annual return has exceeded that of the Bloomberg Barclays 1-3 Year U.S. Government/Credit Bond index. Compared to the Bloomberg Barclays U.S. Long Government/Credit Bond index, the aggregate index's average annual return is lower, but so is its volatility. Its five-year Sharpe ratio (0.72) is superior to that of the short (0.68) and long (0.60) indexes. A core bond fund can be a source of stability — an anchor — in any market environment. As interest rate headwinds wane, investors who want to improve their balance should first strengthen their core.

Jim Gubitosi is senior portfolio manager at Income Research & Management, Boston. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.