Since March 2015 the Portfolio Consulting Group (PCG) has provided comprehensive reviews of over 600 model portfolios. These reviews offer deep insights into our clients’ investment objectives, process, and challenges. In the latest cut of information, we found that fixed income investing and the potential for rising rates were top of mind for financial advisors.

We’ve outlined four steps advisors can follow to navigate the current trends in fixed income.

1. Determine Your Goal

The advisors we spoke with said protection and income generation were the two most important components of their fixed income sleeve. Traditionally, bonds are added to a portfolio as ballast against equity market declines. Reducing interest rate risk while still targeting the same return usually means taking on more credit risk and reducing the potential protection benefit of your fixed income sleeve.

We found the average model in our review has taken on more credit risk and less interest rate risk than the benchmark Bloomberg Barclays U.S. Aggregate Bond Index. While this sleeve has historically outperformed the benchmark in rising rate environments, it provides far less protection potential during equity selloffs.

2. Choose an Approach

Most models combine top managers in several bond categories without considering how they interact with one another. This approach is akin to mixing together a vibrant paint palette until it all turns brown. By considering the purpose of each strategy in the portfolio, advisors can reach their desired credit and interest rate risk profile using several different frameworks. Some common approaches include core/satellite, barbell, outsourcing to unconstrained, and laddering.

3. Understand Bond Categories

Understanding fixed income categories and indices is a critical step in selecting a fund. Unfortunately, most categories are not well defined. Bond benchmarks are difficult to track and less intuitively weighted than equity indices, meaning strategies may deviate from their prospectus benchmarks. Dispersions in credit quality and interest rate risks can also be wide.

4. Manager Selection

A manager’s track record can be informative, but it may not tell the entire story. Historically, in a benign credit environment, taking credit risk outside of the benchmark index has been rewarded with better performance. If the market turns, though, the same high-flying funds could experience larger drawdowns than more conservative funds. To see if performance persisted through all credit conditions, we split the intermediate bond fund universe into quintiles based on performance since March 2009. We found the top long-term quintile posted losses in rocky credit conditions while the worst performing quintile recorded positive returns.

Fixed income investing in the current low rate environment is challenging, but rising to the challenge has never been more important given today’s elevated valuations across asset classes.

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