The historic volatility and losses that impacted virtually all major fixed-income asset classes throughout the first half of 2022 has delivered an obvious silver lining: Rates are higher, valuations are cheaper and fixed-income investors now have a large opportunity set they can draw on to reallocate and rebalance their asset allocations. In the current environment, we are primarily focused on two specific types of fixed-income solutions: defensive and dynamic.
Defensive: The year-to-date sell-off across all fixed income provides many opportunities for investors to increase their exposure to historically defensive, high-quality investment grade sectors carrying yields that have been more recently reserved for higher-risk areas of the market. Among these defensive sectors, we see opportunities to add to several areas of the securitized markets — particularly agency mortgage-backed securities, where yields are materially higher than in many other defensive sectors. In addition to relatively high yields, we are mindful that these defensive sectors also offer greater return potential if growth meaningfully slows, we enter a recessionary environment and rates go down from this point forward.
Elsewhere in the defensive universe, the yield-curve inversion is a boon to conservative core fixed-income investors: the inversion means short-term bonds now potentially generate higher yield than intermediate term, while at the same time carrying less duration risk.
Dynamic: Whereas purely "defensive" fixed income consists of only high-quality investment grade sectors, investors willing to take on additional risk within the "40" of their 60/40 portfolio may consider complementing with a solution that dynamically combines some elements of equity diversification with higher income potential. The current environment presents attractive discounts (and even dislocations) in many high-risk and high-yield asset classes. However, investors would be wise to remain cautious and expect further volatility and losses to accompany the current high-return potential of these asset classes. Against this backdrop, dynamic strategies can help "rerisk" core fixed-income overweights and/or "derisk" overly aggressive fixed-income allocations. These types of solutions actively allocate to areas of the market that appear attractive while remaining flexible to increase or decrease the portfolio's risk budget in response to changing market conditions.
In conclusion, we do not believe the 60/40 portfolio is dead, but we do think it is experiencing something of a midlife crisis in the sense that it's experiencing rapid change after what was a roughly 40-year bull market in core fixed income. In our view, we have now reached the point where investors should attempt to put recent volatility behind them, view the current landscape as a blank slate and seek to take advantage of new opportunities in a higher-yield environment. The question shouldn't be if they should take advantage, but how — and the solutions we have outlined can play a critical role.
This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.