Enhancing Fixed Income Efficiency Through Diversification

We see two key developments in the global economy and financial markets with implications for fixed income:

1. In the current environment, we believe that global economic growth will continue at a high clip but may plateau at some point for an extended period.

  • U.S. economic growth is robust, and we believe it will be sustained by the additional fiscal stimulus from the tax and budget bills in Congress.
  • Yet the leadership of growth has been moving away from the United States to the rest of the world—a trend we believe is likely to continue.

2. Central-bank policy is beginning to affect returns on U.S. and global fixed income instruments.

  • The U.S. Federal Reserve (Fed) is well on its way to normalizing policy.
  • In its policy, the Fed has the potential to become restrictive to growth if it hikes interest rates too rapidly.
  • The differentials in the pace of economic growth between the United States and the rest of the world may not benefit the U.S. dollar, which appears to remain in a down trend, at least for the medium term.
  • This trend is allowing for inflation to ease—particularly in emerging markets—and for some policy flexibility.

We see the following implications for fixed income portfolios:

  • Limited term U.S. fixed income instruments, in our view, can provide for an attractive investment in the current environment: They currently provide more than 80% of the aggregate bond market yields with relatively low interest rate risk.
  • The U.S. yield curve is at one of its flattest position in years. If it steepens, short duration bonds may benefit.
  • With real yields still at elevated levels in emerging markets and the dollar declining, we think international fixed income can provide an efficient combination with U.S. fixed income. Pairing international bonds with their limited-term U.S. counterparts may satisfy the needs of many investors who seek higher yields and greater risk-adjusted returns.

In general, we favor a mixed allocation, equally divided between limited-term, investment-grade bonds in the United States and opportunistic exposure to international fixed income.

Let’s take a closer look at each.

U.S. Fixed Income

Limited-term U.S. bonds have historically been relatively lower-risk assets when looking at maximum drawdowns. Over the 20-year period ending March 31, 2018, they’ve experienced a peak-to-trough drawdown of -1.11%, reduced risk (as expressed in their standard deviation of just 1.38), and a maximum Sharpe ratio of a little more than 1.1

Currently, with the U.S. yield curve at its flattest position in many years, these bonds may offer the additional benefit of providing nearly 80% of the yield of the aggregate bond market (Exhibit 1).

Exhibit 1: Limited-Term U.S. Bonds Currently Provide Nearly 80% of the Yield of the Aggregate Bond Market

The flat U.S. Treasury yield curve also offers the possibility that when it steepens—whether because of worsening economic conditions, or if inflation surprises on the upside—then short-duration bonds will most likely benefit relative to longer-duration bonds (Exhibit 2).

Exhibit 2: The 10-Year U.S. Treasury Yield Minus the 2-Year U.S. Treasury Yield Is Currently at Its Lowest Point in 10 Years

International Fixed Income

As economic growth differentials have shifted—with the leadership of growth moving away from the United States to the rest of the world toward the end of 2015—the U.S. dollar has been declining. In this environment the Fed has been able to raise interest rates without strengthening the U.S. dollar. We expect this trend to continue in the medium term. We also expect that the current stimulus being added to the U.S. economy while it is still at full employment will lead to an increase in the current-account deficit. Currently, compared with other developed market currencies, the U.S. dollar is roughly valued at its 15-year average (Exhibit 3)—in our view a fairly attractive valuation in the medium term for investors who wish to diversify their holdings in non-U.S. investments—but it is slowly declining, as the United States must pay for its current-account deficit.

Exhibit 3: The U.S. Dollars Current Valuation Compared to Other Developed-Market Currencies Is Approximately Equal to Its 15-Year Average

The U.S. dollar’s decline and corresponding rise in non-dollar currencies has added to the cyclical deflationary trend in many countries. As inflation and inflation expectations continued to drop in emerging markets, real yields there have risen and are now at a significant premium to those in the United States and other developed markets (Exhibit 4). We believe this premium may decline over the next few years as the economic-growth differentials narrow between the United States and the rest of the world.

Exhibit 4: Real Government Bond Yields in Select Emerging-Market Economies Are Currently Significantly Higher than U.S. Government Yields and Those of Other Developed Markets


The roles of fixed income in a diversified portfolio can vary. However, investors tend to view the asset class as a relatively safe investment that can provide income potential and help serve as ballast in their portfolios. Given the rising-rate environment in the United States—and one of the flattest yield curves we’ve seen in the last decade—we believe limited-term U.S. fixed income exposure across high-quality corporates, structured credit and agency mortgages may provide more stable performance.

If investors consider expanding their opportunity set to include international bonds, which consist of government and corporate debt from developed and emerging markets, they may find a great complement to limited-term U.S. fixed income. International bonds may also offer higher yields, help reduce a portfolio’s sensitivity to changes in U.S. interest rates, and enhance portfolio diversification since they historically have had a low correlation to the Bloomberg Barclays U.S. Aggregate Bond Index (which stood at 0.53 during the past 5-years ending March 31, 2018). Finally, we believe that active currency management may provide a source of additional returns.2

In summary, it is our view that an equally split (50/50) fixed income portfolio—divided between exposure to limited-term U.S. bonds and international opportunistic fixed income strategies— may provide an attractive risk/return profile for fixed income investors.

  1. ^Sources: FactSet, Credit Suisse, Bloomberg and Bloomberg Barclays, as of 3/31/18. Asset class representations and index definitions can be found below. Past performance does not guarantee future results.
  2. ^Source: Morningstar for the five-year period ending 3/31/18. U.S. Aggregate and International Bonds are represented by the Bloomberg Barclays U.S. Aggregate Bond Index and the Citigroup Non-U.S. World Government Bond Index. Past performance does not guarantee future returns.

Glossary of terms and index definitions:

Maximum drawdown: The peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted as the percentage between the peak and the trough.

Standard Deviation: A measure of the dispersion of a set of data from its mean. The higher the dispersion, the higher the deviation. A large dispersion tells us how much the return on the fund is deviating from the expected normal returns.

Duration: A measure of the sensitivity of the price (the value of principal) of a fixed income investment to a change in interest rates. Duration is expressed as a number of years.

Sharpe Ratio: A ratio to measure risk-adjusted performance. The Sharpe Ratio is calculated by subtracting the risk-free rate—such as that of the 10-year U.S. Treasury bond—from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns.

Select asset classes include Short-Term Bonds, High Yield Bonds, Intermediate-Term Bonds, Emerging Market Bonds, Senior Loans, and U.S. Stocks.

Short-Term Bonds are represented by the Bloomberg Barclays U.S. Aggregate (1-3 Year) Index. The Bloomberg Barclays U.S. Aggregate (1-3 Year) Index is an unmanaged index of publicly issued investment-grade corporate, U.S. Treasury and government agency securities with remaining maturities of one to three years.

Intermediate-Term Bonds are represented by the Bloomberg Barclays U.S. Aggregate Index. The Bloomberg Barclays U.S. Aggregate Index is an unmanaged index of publicly issued investment-grade corporate, U.S. Treasury and government agency securities.

High Yield Bonds are represented by the Bloomberg Barclays U.S. High Yield Index. The Bloomberg Barclays U.S. High Yield Index covers the universe of fixed rate, non-investment-grade debt.

Senior Loans are represented by the Credit Suisse Leveraged Loan Index. The Credit Suisse Leveraged Loan Index is a composite index of senior loan returns representing an unleveraged investment in senior loans that is broadly based across the spectrum of senior loans and includes reinvestment of income (to represent real assets).

Emerging Market Bonds are represented by the JPMorgan EMBI Global Diversified Bond Index. The JPMorgan EMBI Global Diversified Bond Index is a uniquely weighted version of the EMBI Global Index, which limits the weights of those countries with larger debt stocks by only including specified portions of these countries’ eligible current face amounts of debt outstanding.

U.S. Stocks are represented by the S&P 500 Index. The S&P 500 Index is a stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ.

The Bloomberg Barclays US Aggregate Bond Index is often used to represent investment grade bonds being traded in United States.

The Citi World Government Bond Index (WGBI) measures the performance of fixed-rate, local currency, investment grade sovereign bonds. The WGBI is a widely used benchmark that currently comprises sovereign debt from over 20 countries, denominated in a variety of currencies.

The indices are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and is not intended to depict or predict the performance of any particular investment.