Traditional long-only fixed income managers had one of the worst quarters on record in Q1 2022 as higher interest rates left “bottom up” portfolios overweight duration. As we have discussed before, in a world where macro variables drive returns, owning 1000s of individual bonds leaves the impossible task for controlling credit and duration risk at the portfolio level. Instead, portfolios constructed with illiquid individual bonds become “index-like” and static, unable to react to new information and new regimes. Although we don’t think the pain is over for these types of portfolios, we do believe that fixed income – even in a world where inflation and interest rates are rising – can still be prudently used to help diversify and protect a portfolio from equity drawdowns. To thrive, managers will need to use liquid alternatives that allow for creative solutions and macro positioning in a low-cost way. The basic 60/40 portfolio might not be as dead as many believe- it just looks different.
Specifically, to be an effective fixed-income investor going forward may require using tools that separate credit from interest rate risk and allow investors to be nimble enough to manage cyclical trends within a secularly shifting world. To this end, we are frequently asked two questions 1) what is the best way to use Treasuries to manage duration?, and 2) why have any duration at all?
These questions are a bit more complex than they appear. First, cycles almost always overwhelm a secular view. Case in point, during the 40-year bull market in Treasuries there were 9 periods lasting a year or longer (11 years of the 40) where government debt lost more than 5% per year. In other words, throughout the entire 4 decades, a static portfolio left money on the table versus an actively managed one. Tactical duration management will be a key to navigating a secular rising rate environment marked by intermittent periods where yields fall.
Duration comes in many shapes and sizes, especially when constructing a portfolio with ETFs that allow for rate hedged products, and fixed-income investors will need to be creative. There has been a meaningful increase in the breadth of fixed income ETFs over the past few years, which now allows investors to be very specific about the type of interest rate and credit exposure they target. Further, ETFs allow managers to be very nimble and deviate from their benchmarks without the need to turn over huge portions of their portfolios to change those exposures.