For example, as illustrated in Figure 1, the majority of active US core-plus, global credit, and global aggregate fixed income strategies that are typically intended to serve a defensive “risk-aversion” function in client portfolios have displayed an alpha profile that has arguably been dependent on beta-heavy, risk-seeking, cyclically-oriented credit risk factors. We venture to say that many end fixed income allocators would likely not be comfortable with that level of credit risk — and it could also lead to other unwelcome portfolio implications for allocators.
Notably, the alpha profile associated with these risk factor leanings could be highly correlated with the performance of other potential sources of return in an investor’s portfolio, such as equities and liquid alternatives. Consequently, investors constructing fixed income portfolios around core “risk-aversion” bond allocations and selecting active managers to implement the underlying security selection may well be losing some portfolio diversification benefits to factor and other structural biases. That’s why we believe understanding an active manager’s path and style of alpha generation should be a critical part of anyone’s manager evaluation process.
This is not to say an overweight credit risk style of investing doesn’t have a place in portfolios. A critical area of focus for capital allocators should continue to be monitoring their active managers’ alpha-generating style biases. To ensure adequate diversification benefits, consider adopting a robust portfolio construction and manager selection process designed to source complementary manager alpha-generation styles. In this way, “smoothing out” the path of fixed income alpha and aligning a manager’s style with the intended role of a bond allocation can help optimize overall cross-asset portfolio outcomes.
Final thoughts on fixed income alpha
Given the historic recent backdrop for credit-risk-driven returns, with the resulting valuation proposition existing today, we believe there is arguably limited future upside for outright directional overweight to cyclical credit risk in the period ahead. At the same time, fixed income investors these days are increasingly feeling the pinch of every incremental bit of bond market volatility. To help address these challenges, the Fundamental Factor Team is developing a factor-based fixed income manager selection framework for today’s environment.