With equities hovering near all time highs and baby boomers fueling demand for income solutions, bond investing -yield, capital preservation and risk management is as important as ever, according to Legg Mason.
However, given persistent low interest rates, investors may need to consider a broader set of sectors and geographies, and potentially take more credit and interest rate risk.
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Meeting these needs and navigating risk is leading to new strategies and solutions highlighted by unconstrained bond strategies, which can offer savvy investors attractive options.
"As interest rates begin to normalize, many investors are reexamining their fixed-income allocations," said Donald H. Plotsky, Head of Product Group at Western Asset Management, a Legg Mason affiliate.
"Choices include standing firm, rotating out of fixed-income or moving to an unconstrained strategy."
For many investors, Mr. Plotsky advises investing in unconstrained bond strategies, which generally do not adhere to a specific index. As a result, they are not required to own explicit sectors, weightings, markets or credit qualities. This flexibility can be valuable in the search for capital enhancement and income while managing the risk that comes with rising interest rates.
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By GlobalData"In an era of financial repression and manipulated government bond rates, particularly in the developed markets, traditional market benchmarks currently offer low yields and long duration."
He thus advises against being limited by the conventions of the Barclays Aggregate Index, comprised only of U.S. bonds: government, investment-grade credit and securitized.
"This index excludes a substantial portion of the investable fixed-income universe," he said, including floating-rate, inflation-linked, non-US, private and below-investment-grade securities. "These represent roughly 65 percent of the investable fixed-income universe."
With a broader spectrum of choices, Mr. Plotsky believes unconstrained bond funds offer enhanced opportunities, as well as other valuable benefits.
"If we consider how we traditionally utilize fixed-income — as an offset to the equity risk that tends to dominate investors’ portfolios and as a source of income that seeks to stabilize overall portfolio returns — then we understand that exiting fixed-income entirely could substantially increase portfolio risk," he said.
"Unconstrained investing allows investors to seek the desirable characteristics of fixed-income — income, diversification and risk management — and avoid the undesirable — longer duration and high correlation to government rates."
It is in such correlations that Mr. Plotsky sees potential trouble for some investors.
"While some might consider an alternative index rather than unconstrained, we believe that all fixed-income indices have limitations," Mr. Plotsky cautioned. "They are generally market-weighted, which results in allocations based on issuance patterns rather than any sense of value. This facilitates liquidity, but tends to reward the profligate and can, at times, punish investors."
Given that these are relatively new products in the fixed-income world, the factors that must be considered before committing to an unconstrained strategy require careful deliberation.
"Unconstrained strategies are not all the same and many of them are not even comparable," Mr. Plotsky explained. "Investors need to fully understand the risk and return objectives for a particular strategy and must evaluate each strategy based on its unique approach and characteristics."
On the whole Mr. Plotsky sees unconstrained bond strategies proving highly beneficial.
"We believe that fixed-income benchmarks have certain inherent flaws that make an unconstrained approach a viable alternative in all markets," he commented. "We strongly believe that unconstrained strategies can present very attractive investment opportunities in an otherwise uncertain environment."
