Unconstrained: Stay Active

Fixed income

Unconstrained: Stay Active

Income and global credit are becoming mainstays of fixed-income investing – an actively managed, unconstrained approach can be a valuable tool to face today's rapidly-changing market conditions.

Executive Summary

  • With markets now hostage to shifting global macro conditions and different sources of market risk, we are taking this opportunity to re-emphasize the value of active fixed-income management.
  • After a multi-year period of low yields and little market volatility, we are finally seeing select value and diversification opportunities arise heading into the new year.
  • In our view, income generation via global credit will become an increasingly integral part of investors’ preferences, and active sector rotation will be essential.
  • We see EM as the most undervalued asset class and one that would be the biggest beneficiary of any attenuation of global risks.
  • An unconstrained investing approach could afford the necessary flexibility to exploit the most desirable characteristics of fixed-income: income and return, diversification and preparation for risk.

Unconstrained Investing: Stay “Active” in These Uncertain Times

This year, investors have been blindsided by bouts of sudden and sharp volatility across equity, fixed-income, commodity and currency markets. Market angst has been amplified by fears of slowing global growth, the inability of central banks to inspire confidence around policy normalization, tighter financial conditions, and a dizzying array of idiosyncratic risks coming out of both developed markets (DM) and emerging markets (EM). Spread sectors held up well over the first half of 2018. Since then, the combined weight of these factors has weakened market sentiment and depressed valuations across the bulk of the credit spectrum (Exhibit 1). US Treasury (UST) bonds also succumbed to the market’s gravitational pull as US growth optimism and glib comments by Federal Reserve (Fed) Chair Jerome Powell propelled US rates to a multi-decade wide versus most other G-10 countries.

Exhibit 1: Year-to-Date Excess Returns

Note: Figures reflect S&P/LSTA Performing Loans Index excess return vs. 3-Month LIBOR

Source: Bloomberg Barclays, J.P. Morgan, S&P Global Market Intelligence, a division of S&P Global Inc, Western Asset. As of 30 Nov 18.  Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Recent US mutual fund and exchange-traded fund (ETF) flow activity reflects this heightened state of market anxiety. Exhibit 2 shows that after a sizable AUM build-up in the passive taxable bond segment, following the oil price collapse of 2015, demand has fallen off considerably in 2018 with the bulk of the decline observed over the past few weeks. Most notable is the sharp reversal in corporate, high-yield and bank loan flows and the surge into the combined short-term and ultrashort bond segment. This dynamic should not be surprising.

In a paper we published last year, Global Investing: The Price You Might Pay for Going Passive, we cautioned investors over the misplaced euphoria and growing herd mentality around passive fixed-income products that was fueling a supply boom during an extended period of low volatility. We underscored the product shortcomings: an overweight bias toward the largest debtors, the inability to exploit off-benchmark opportunities, an asymmetric duration risk (i.e., less yield compensation), and the propensity to take on greater tracking error (and to potentially lock in underperformance) due to index replication constraints. We also argued that while a passive approach might make sense for highly liquid and well-researched markets such as US large cap equities or US government bonds, extending this approach to less transparent and  less liquid markets such as high-yield or EM meant foregoing opportunities to enhance returns and effectively manage portfolio risk.

Exhibit 2: Passive Fixed-Income ETF flows

Source: Morningstar, as of 31 Oct 18.  Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.


With markets now hostage to shifting global macro conditions and increasingly varied sources of market risk (e.g., US-China trade tensions, Brexit, Italy, etc.), we are taking this opportunity to once again remind investors of the drawbacks of passively managed fixed-income products and the value of active fixed-income management.

Highlighting Risks and Opportunities

After a multi-year period of low yields and little market volatility, we are finally seeing select value and diversification opportunities arise heading into the new year. Investors are asking which sectors look attractive, what investment solutions might best be suited to exploit those sectors and what market-jolting event may lie around the corner. Below, we provide our latest thoughts on a number of areas relevant for fixed-income investors.

Top-Down View

Looking back on 2018, market expectations for a continuation of synchronized global growth were upended by an acceleration of US growth beyond consensus estimates, slower global growth and various idiosyncratic risks stemming from EM countries. Exhibit 3 shows the divergence in the revisions to US and non-US growth as the year has progressed, which has resulted in broad-based US dollar strength, higher US interest rates and higher risk premia across spread sectors globally.

Exhibit 3: J.P.Morgan Growth Forecast Revision Indices

Source: J.P.Morgan, as of 31 Aug 2018. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.


Looking ahead to 2019, we expect US growth to slow slightly as the impact of fiscal stimulus wanes and the pernicious effects of tariffs weigh on key pillars of the economy (e.g., housing and autos). Absent an acceleration in nominal GDP and without any real signs of sustained wage pressure, we also view any upticks in inflation in the near-term as merely transitory. We expect the Fed to continue to move cautiously and adjust policy as needed, based on market realities and not on static models. Our hope is for clear communication and minimal uncertainty as unexpected monetary policy moves will undoubtedly lead to even greater volatility.

Without doubt, the greatest threat to the global recovery is the prospect of a global trade war. As discussed at length in our recent paper, Trade Wars in the 21st Century: Perspectives From the Frontline, market prices may already reflect some of the downside risks and we may have now seen the worst of the tough trade talk between the US and China. However, one cannot ignore the possibility that trade tensions may worsen before or after the 90-day “pause” agreed to by the US and China at the G-20 summit.

With this downside risk on full display, one might question how it is possible to be even modestly constructive in our market outlook. We would argue that there are glimmers of light amidst the gloom. First, the Fed has already begun to walk back its hawkish rhetoric. Second, despite massive market pessimism about the challenges of Brexit and Italy (which we believe are misplaced), European growth has been sturdy; we expect this to continue as the Bank of England and the European Central Bank (ECB) continue to be highly focused on underwriting their respective expansions. Third, while the US-China trade dispute has introduced tremendous uncertainty in the global economy, it has engendered a course correction in Chinese economic policy. Gone is the deleveraging campaign of earlier this year. Interest rate cuts, reserve requirement reductions, targeted fiscal spending increases and a renewed lending to the private sector suggest slowing Chinese economic growth will reverse over the next several quarters.

Last, extreme market pessimism pulled the entire EM asset class downward this year despite important positives in the sector such as remarkably subdued inflation and resilient sovereign and corporate balance sheets. Consider these statistics:

  1. Yield spreads between EM and DM debt are near 2008 and 2016 wides;
  2. Currency levels are the lowest in nearly 20 years and are 35% lower than just five years ago;
  3. The real yield of EM debt is at a 15-year wide versus the real yield of DM debt. Our view is this asset class would be the biggest beneficiary of any attenuation of the global risks highlighted above.

Bottom-Up View

Corporate fundamentals continue to be strong across the majority of sectors and earnings are supportive of credit investing. That stated, we are mindful of growing market concerns in certain segments of the market, particularly BBB rated credit (which we addressed in more detail in An Update on BBBs) and the downside risks from an escalation in global trade tensions. Exhibit 4 charts a summary of our bottom-up valuation views on the key credit markets, thoughts on each sector and where we currently see compelling relative value opportunities within each market.

Advocating Unconstrained Investing

Given the still low levels of interest rates globally, we believe income generation via global credit in all of its forms—corporate debt, structured credit and sovereign debt to name a few—will become an increasingly integral part of investors’ portfolios and active sector rotation will be essential. Bear in mind that credit sectors do not necessarily move in tandem; they have different cycles and they do well in different environments.


Exhibit 4: Global Credit Market Views


Source: Western Asset, 30 Nov, 2018.  Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.


Therefore, the ability to tactically emphasize one sector and de-emphasize another to find value and drive alpha in a diversified portfolio will be vital for performance.

Not being benchmarked or tethered to the low levels of benchmark rates will be just as important. We emphasize this because strategies that look to beat a benchmark inherently have to be conscious of tracking error and, as a result, managers may own sectors that they have to live with rather than those for which they have a strong conviction. For example, the surge in US government borrowing over the past decade means USTs now total approximately 35%-40% of the Bloomberg Barclays US Aggregate Index—in line with the percentage of USTs issuance versus total debt (see Exhibit 5). Passive strategies linked to this benchmark are prone to lower yields and potentially lower returns as more UST issuance squeezes out higher-yielding securities.

In the papers we’ve published, our case for advocating an unconstrained investing approach rested on the inherent shortcomings of benchmarks and the greater flexibilities unconstrained strategies enjoy to confront duration risk and seek value opportunities. These arguments have not become obsolete. If anything, the resurgence of market volatility and expectations that this will continue only strengthen the case for unconstrained strategies given their ability to exploit the most desirable characteristics of fixed-income: income and return, diversification and risk mitigation.

Exhibit 5: Percentage of Debt Issuance by Category

Source: Securities Industry and Financial Markets Association (SIFMA), as of  30 September 2018.  Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Exhibit 6: Yield-to-Worst vs. Historical Correlation—Last 10 Years

Source: Bloomberg Barclays, as of  30 November 2018. Yield and volatility statistics reflect US dollar-hedged data. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.


See Exhibit 6, which plots the yield-to-worst of select fixed-income markets against their respective correlation to equities over the past decade. Given the variety of securities across today’s global credit markets, an unconstrained investing approach affords the investment manager the necessary flexibility to build a more diversified portfolio that incorporates both income- (and return-) generating assets as well as defensive (or risk-mitigating) assets. This is much harder to accomplish using a passive or traditional benchmarked approach.

We would also highlight the negative correlation that global government bonds have with equities (using the S&P 500 as a market proxy). We have long argued the value of holding government bonds, with a particular emphasis on USTs, mainly for their ability to act as ballast against spread risk in a broad investment portfolio, especially during turbulent market periods. Recent divergent price action of US equities and USTs continues to support this view.

The keys to selecting the “right” unconstrained solution(s) are clarity and transparency around expectations and tolerance of portfolio risk, the investment opportunity set and volatility in returns. Some of the investment approaches can be somewhat ad hoc and are not always clear as to the nature of the risks involved.

That’s the reason we believe it is essential to consider three key parameters when thinking about an unconstrained approach:

  • Volatility tolerance: low, moderate or high?
  • Opportunity set: what type of assets will the portfolio hold?
  • Sources of alpha: will it be credit spread focused, macro focused or a combination of the two?

Since there is no “one-size-fits-all” approach to unconstrained investing, we believe it is essential to consider a range of strategies, keeping in mind the risk and return objectives of each. For example, over the past few years, a growing number of investors have chosen to invest in multi-asset credit strategies to meet the challenge of credit sector selection. Unsurprisingly, these strategies generally have a volatility range that reflects their underlying credit opportunity set, which can include but is not limited to corporate bonds, EM debt and structured securities. Given their credit-heavy orientation, the major sources of alpha in such strategies over time would come from spread sectors.

Other investors have demonstrated a preference for more global or macro-oriented unconstrained strategies. These typically exhibit the same level of volatility as traditional global indices such as the FTSE World Government Bond Index or the Bloomberg Barclays Global Aggregate, yet avoid exposure to low and negative yielding markets such as Europe and Japan to improve their risk and return profile. The opportunity set for these strategies is more biased toward investment-grade and the sources of alpha come from rates and currencies. Higher volatility macro strategies, which incorporate a wider opportunity set and have looser sector and credit-quality constraints, have also increased in popularity as they are less correlated with traditional beta and sit outside the traditional growth and defensive allocation framework.



The resurgence of broad market volatility and pullback in passively managed fixed-income flows this year underscore our view that active management in fixed-income is here to stay. These developments also serve as a timely reminder that unconstrained investing could be a viable and attractive complement to traditional benchmarked strategies or to an alternative approach in a wide variety of market environments. As we laid out in our top-down and bottom-up views, the coming year will likely see more bouts of volatility stemming from a number of flashpoints in both Emerging and Developed markets. With this in mind, we encourage serious consideration of active management, especially in the context of of unconstrained investing, as it could potentially afford flexibility to confront risk, as well as to seek value opportunities as they arise.



Emerging markets (EM) are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed   countries.

The Federal Reserve Board (“Fed”) is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

The Group of Ten (G-10 or G10) refers to the group of countries that agreed to participate in the General Arrangements to Borrow (GAB), an agreement to provide the International Monetary Fund (IMF) with additional funds to increase its lending ability.

Exchange Traded Funds (ETF) are a type of investment company which are bought and sold on a securities exchange. ETFs generally represent a fixed portfolio of securities, derivative instruments, currencies or commodities. The risks of owning an ETF generally reflect the risks of owning the underlying securities or commodities they are designed to track. ETFs also have management fees and operating expenses that increase their costs.

Duration is a measure of the price sensitivity of a fixed-income security to an interest rate change of 100 basis points. It is calculated as the weighted average of the present values for all cash  flows.

Gross Domestic Product (“GDP”) is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of  time.

The Group of Twenty (also known as the G-20 or G20) is an international forum for the governments and central bank governors from 20 major economies, respectively. The G-20 members include 19 individual countries—Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, the United Kingdom and the United States—along with the European Union (EU). The EU is represented by the European Commission and by the European Central Bank.

The European Central Bank (ECB) is responsible for the monetary system of the European Union (EU) and the euro  currency.

A spread is the difference in yield between two different types of fixed income securities with similar  maturities

Government-sponsored enterprise (GSE) includes Freddie Mac, Fannie Mae and Ginnie Mae. GSEs were chartered by Congress in 1970 to keep money flowing to mortgage lenders in support of homeownership and rental housing for middle income Americans.

The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S.

Alpha is a measure of portfolio performance vs. a benchmark, relative to the volatility of that benchmark. An alpha greater than zero suggests that the portfolio has outperformed during the period by means other than adding volatility.

The Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index that measures the performance of the investment grade universe of bonds issued in the United States. The index includes institutionally traded U.S. Treasury, government sponsored, mortgage and corporate securities.



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