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August 20, 2020 | GSAM Connect

Did Your Core Fixed Income Strategy Weather the Storm?

When skies are always sunny, it’s easy to forget that it can rain. That’s what some investors did during the longest equity bull run in history—the one that ended abruptly when the coronavirus cloudburst hit in March.

When global growth was strong and markets were booming, taking on beta and boosting exposure to return-seeking assets—equities, high-yield credit, emerging markets—seemed like the smart thing to do. But when the weather changed, many of those higher-risk assets came under heavy selling pressure. Since then, two-way market moves have become more common, making it harder to predict performance across asset classes. For a brief moment in March, even US Treasuries, an asset class many investors perceive to be safe, were hit.

When markets move swiftly, we believe investors must be well-positioned to capture opportunities as they arise. But those who lacked balance between risk-reducing and return-seeking assets when the pandemic hit likely had a hard time piloting their portfolios through the storm.

This was apparent among intermediate term core fixed-income strategies, which aim to provide relative stability, income, and diversification against equity risk throughout a market cycle. As Exhibit 1 illustrates, the dispersion of returns among US core fixed income mutual funds has been much greater in the first half of this year than it’s been over the last 10.

EXHIBIT 1: Dispersion of Returns Among Morningstar US Intermediate Core Bond Mutual Funds

Source: GSAM, Morningstar. As of 6/30/2020. Dispersion of returns shown for mutual funds (all share classes) in the Morningstar US Fund Intermediate Core Bond Category. # of Investments: YTD: 420; 10Y: 342. Returns less than 12 months are cumulative, not annualized. Past performance does not guarantee future results, which may vary.

 

We suspect this is because many core strategies followed the crowd and have reduced their higher-quality exposure (AAA and AA-rated bonds) in favor of lower-quality, higher-risk fixed income assets over the last decade1.The potential problem with that approach? Risk-seeking fixed income assets such as high-yield credit and emerging market debt typically have exhibited higher correlation to the S&P 500 and therefore have behaved more like equities during down markets2.

How can investors build a core strategy that offers consistency and seeks to provide ballast when the sea gets stormy? Here are three key rules that we think a solid core foundation should live by:

  • Be “style-pure” by focusing on investment-grade bonds that offer income and capital appreciation potential while helping to diversify equity risk
  • Take advantage of the full global investment-grade universe, which can enhance diversification and risk-adjusted return potential
  • Balance exposure to interest-rate and credit risk. This can help investors participate in market upside while potentially reducing downside risk

When it comes to the foundation of your fixed income allocation, we believe consistency matters. 

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