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Last May, we introduced a mix of risk-managed alternative fixed-income strategies with the goal of further diversifying our recommended fixed-income allocation. With yields still low on a nominal and real (inflation-adjusted) basis, traditional or core fixed-income holdings may potentially drag down portfolio returns as market yields either increase (potential price declines) or stabilize (low cash flow). If bond yields increase from recent levels, these holdings are also subject to heightened market risks, which are magnified the greater an investor’s allocation is to traditional Fixed-Income. We still believe strongly that core Fixed-Income plays an important role in a portfolio, but we wanted to provide another fixed-income “sleeve” to potentially augment its return capability in what is best characterized as a challenging yield environment.

The term “active” Fixed-Income maybe a good substitute for “alternative” Fixed-Income. When we use either of these terms, we are referring to a truly unconstrained portfolio of fixed-income securities in which a manager has the latitude and access to employ a variety of strategies for both managing risk and generating return.This includes the ability to short specific securities, sectors or the bond market in general. Two of our recommended managers can actually have a negative duration, which provides the opportunity to profit in an environment of increasing bond yields. A good analogy of the active/alternative fixed-income manager would be the person who takes on a home improvement project of installing a new door. This person could probably complete the job with a screwdriver and drill, but would likely do a better job with access to a level,and an even better job with a wood plane to smooth out any irregularities on the door’s edge. The active/alternative fixed-income managers we recommend have the access to additional tools, allowing the use of more strategies than traditional managers when taking advantage of portfolio opportunities.

The goal of our alternative fixed-income allocation is very simple: to provide a return pattern that is independent of the direction of market yields utilizing fixed-income securities, sectors and strategies. In other words, to provide further portfolio diversification,specifically in the area of Fixed-Income by attempting to mitigate interest rate risk. This is accomplished via three separate managers, all attempting to achieve roughly the same objective but with different strategies to do so. The objective is a return of cash plus 3%, with a volatility of equal to or less than the overall bond market, and each of the three managers actively manages interest rate and credit risk. The three managers and a brief description of each are listed below (the percentage number following the manager’s name is the recommended weight in the mix):

  • Driehaus Active Income Fund (40%) – Bottom-up, fundamental long/short credit manager; duration target +/- 1 year
  • JP Morgan Strategic Opportunities Income Fund (40%) – Top-down, thematic, global diversified absolute return fixed-income  manager; duration target -2 years to +5 years
  • Palmer Square SSI Alternative Income Fund (20%) – Fundamental, unlevered convertible bond arbitrage manager

Rising rates caused trouble for traditional fixed-income securities and strategies in 2013. The benchmark10-year Treasury note’s yield began the year at 1.84%, bottomed at 1.63% and ended 2013 at 3.03%. With little “cushion” in the form of coupon payments, this resulted in negative total returns for most sectors of the fixed-income markets. The chart below shows the total return for the various sectors of the bond market for calendar year 2013, including the recommended mix of alternative fixed-income managers.

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Source: Bloomberg, Zephyr, Moneta

Volatility for 2013 across all sectors of the bond market was well below historical averages, and there commended alternative fixed-income mix also experienced very low volatility.The Barclays Aggregate, one of the most widely followed fixed-income indices,had a calendar year volatility of 3.2%, and the combination of the aforementioned three managers had a volatility of 1.6%. In other words, there commended mix provided a positive return in a year when traditional fixed-income strategies were negative and achieved that result with half the volatility of the overall bond market. This attention to risk management was particularly beneficial in May, when bond market yields spiked dramatically.The Barclays Aggregate lost 1.9% in May while the recommended mix was up 0.34%.

While we believe this strategy merits serious consideration in the current yield environment, we fully acknowledge that it may not be appropriate for everyone. First, these funds will be relatively tax-inefficient. All pay a current yield and are actively traded,increasing the opportunities for short-term capital gains. For that reason,they are the best fit for tax-deferred accounts. Second, portfolios with a small allocation to Fixed-Income (less than 20%) have less interest rate risk at the portfolio level. Finally, many investors might choose instead to adjust their asset allocations based on personal risk and reward tolerances and place more in other asset classes. This strategy is most beneficial for investors who hold a significant percentage of their portfolio in bonds with longer-term maturities, which are most sensitive to changes in market yields.