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November 23, 2021 | GSAM Connect

Fixed Income Asset Allocation: A Well-Balanced Approach

BOTTOM LINE

The post-pandemic cycle starts from an unusual position of low interest rates, tight spreads and high valuations. Against this backdrop and as we enter a period of easy policy withdrawal, we think it is important to highlight that our Cross Sector team dynamically navigates the fixed income spread sector universe through strategic and tactical asset allocations, seeking to ensure our clients’ fixed income portfolios are balanced and resilient to tail risks.

1. Give credit to carry and roll

The fixed income universe encompasses more than $75 trillion of securities in market value, around half of which is accounted for by fixed income spread sectors1. Our Cross Sector team is responsible for asset allocation across the broad spread sector universe. These sectors can generate alpha through spread compression or carry and roll. Over time, we find that carry and roll2 is the dominant driver of excess returns. This is why our strategic asset allocation models expected returns on carry and roll adjusted for expected downgrade and default activity (see Appendix in report download). In short, we seek to construct fixed income portfolios that optimize carry and roll over a market cycle.

2. Our process is guided by heads and tails

Our Cross Sector team draws on intellectual viewpoints from across our fixed income platform, with representation from our corporate credit (investment grade, high yield and bank loans), securitized credit, agency mortgage-backed security (MBS) and emerging market debt (EMD) teams alongside Cross Sector investment professionals. Given investment returns do not fit a normal distribution, with actual returns potentially exhibiting ‘fatter tails’ that result in sizeable losses, we balance spread sector exposures with interest rates and developed market (DM) currencies, or some combination of both. These assets can provide balance due to their negative correlation with spread sectors3. In other words, they can perform well when spread sectors underperform. The head of our Cross Sector team, has overall responsibility for asset allocation, namely, the amount of capital allocated to fixed income spread sectors, the composition of that allocation and the degree of balance.

3. The world—and therefore our asset allocation—does not stand still

Our strategic asset allocation and the extent to which we balance spread sector exposures with interest rates or currencies depends on the state of the world as illustrated in Exhibit 1. In an environment of good growth, high interest rates and normal spreads, we align fixed income portfolios with our strategic asset allocation model and balance exposures with rates (top left, Exhibit 1). By contrast, when interest rates are at low levels, we are mindful of their sensitivity to a hawkish policy development, so-called “taper-tantrum risk4”. As such, we reduce or eliminate balance when interest rates are close to their lower bound (lower half). We may also rotate into higher quality fixed income spread sectors when taper tantrum risks are high (top middle), while favoring cyclical assets that have greatest potential for rebound following a negative growth shock (bottom right). Importantly, our approach to both strategic asset allocation and balance is dynamic, evolving depending on the prevailing investment backdrop.

Exhibit 1: A well-balanced approach to strategic asset allocation and balance

Source: Goldman Sachs Asset Management. For illustrative purposes only.  There is no guarantee that a dynamic approach will achieve its investment objective.

Strategic asset allocation (SAA) is customized for our clients’ needs, as we seek to achieve a target return over time. A dynamic approach ensures we take into consideration the shifting investment opportunity set (see Appendix in report download).

Balance concerns the extent to which spread sector exposures are balanced with assets that may provide diversification benefits (due to their negative correlation with spread sectors) such as certain interest rates and currency baskets.5

 

4. We are opportunistic…when the time is right.

Our strategic asset allocation is the ‘home base’ for our clients’ fixed income portfolios. This home is customized for client needs and dynamically evolves as illustrated in Exhibit 1. However, our exposure to fixed income spread sectors over a market cycle is not homebound. We tactically ‘fly the nest’ and strive to capture investment opportunities that may arise in the short- to medium-term due to dislocations in financial markets and relative value investment opportunities as discussed in Exhibit 2 in the full report. For example, we may observe an attractive spread premium in US high yield corporate credit relative to EMD. Meanwhile, within the investment grade market, we may observe attractive carry in BBB-rated bonds relative to A-rated bonds. Our Cross Sector teams’ ability to identify tactical investment opportunities within a sector benefits from close collaboration with specialist investment strategy teams.

5. Bringing it all together

During regular investment meetings and through active debate, we seek to better understand the investment backdrop and refine our asset valuation framework. Dedicated Cross Sector team meetings are complemented with engagements across our fixed income platform. For example, on a quarterly basis, our economics meetings and Fixed Income Strategy Group onsite help us disentangle cyclical dynamics from secular trends. We also solicit a wide range of perspectives during our daily investment Forum which convenes views from internal and external investment professionals, economists and strategists. This assortment of opinions can eliminate group think, combat confirmation bias and provides us with useful market intelligence beyond fixed income. While there is a lot that we can seek to understand about the global economy and investment backdrop, we also recognize that macro and market forecasts are surrounded by wide uncertainty bands. Unpredictable and rare events can have outsized investment consequences, or tail risks. “Black swan” events include financial crises and pandemics, while the potential for “green swan” events stems from climate-related risks6. Overall, we seek to bolster resilience of portfolios to tail risks over an investment cycle through dynamic asset allocation, diversification and balance. Our current asset allocation and balance is illustrated in Exhibit 3 in the full report.

 

Please explore our full report, Fixed Income Asset Allocation:  A Well-Balanced Approach, for more details.

 

1 Fixed Income spread sectors are non-government fixed income securities that provide an additional yield (or ‘spread’) over the yield of a risk-free government bond. In this investment insight, we focus on asset allocation among fixed income spread sectors as informed by our Cross Sector team.

2 Carry reflects an assets expected total return (net of financing costs) beyond price appreciation. It is estimated by the yield differential (or ‘spread’) between a fixed income sector and a risk-free asset (typically a relevant sovereign bond yield). Roll refers to a change in spread from “rolling down” a credit curve over time.

3 Past correlations are not indicative of future correlations, which may vary.

During the taper tantrum in 2013, sooner-than-anticipated monetary tightening generated a sell-off in both risk assets and interest rates.

Past correlations are not indicative of future correlations, which may vary.

See Box A of “The green swan: central banking and financial stability in the age of climate change” (BIS, January 2020). The “green swan” concept finds its inspiration in the concept of black swan events that are unexpected and rare, with wide-ranging or extreme impacts that can only be explained after the fact. Black swan events can take many shapes, from a terrorist attack to a disruptive technology or a natural catastrophe.

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