This year has shown us that no matter how hard we try, we can’t predict the future. But as rational investors, we should do our best to prepare for it. At GSAM, when it comes to portfolio construction we continuously emphasize preparation over prediction, and preparation has to start by looking at—and taking appropriate care of—your portfolio’s core.
Developed market bond yields are near or at record lows and may stay there for years. This has many in the investment community pointing to the evolving role of bonds in portfolios and more specifically to the assumed—and, we believe unfounded—belief that holding bonds in a balanced portfolio is no longer wise.
From a return-generation standpoint, no one can argue against the arithmetic of a negative yielding bond: if bought at issuance and held to maturity it will incur a capital loss. Nevertheless, the term “bond” encompasses a huge variety of diverse asset classes with very different attributes.
In other words, not all fixed income is created equal. In our approach to portfolio construction, core fixed income (CFI) refers to lower volatility fixed income assets—for example, investment grade fixed income—intended primarily for risk management and drawdown mitigation in periods of acute market stress. This definition allows us to clearly distinguish these assets from higher volatility fixed income satellites, such as high yield bonds, that are intended to provide long-term growth in portfolios.
What did we learn from the recent COVID-19 induced equity bear market? X-raying the behavior of equities and government bonds at different maturities for various countries reveals how CFI continues to play a key role in managing risks and mitigating drawdowns (Exhibit 1)—even in today’s low rate environment.