Re‑Evaluating Fixed Income Risks Amid Increased Market Volatility: An Analysis of RIA Portfolios

The risks of fixed income funds and portfolios are not always well understood by their investment categories or sector allocations alone.
Intended for investment professional use only

As market volatility continues to unnerve investors, we observe many Registered Investment Advisers (RIAs) re-evaluating their approaches to fixed income. Most RIAs tell us they still seek the traditional benefits of fixed income: capital preservation, equity risk diversification and an attractive yield. However, it has been challenging to achieve all three simultaneously in the current market environment amid historically low yields, rising U.S. rates and policy divergence that has exacerbated market volatility.

We regularly conduct customized studies for RIAs, and when we analyzed trends across 143 such studies during the second half of 2015, we found that many RIAs have opted to stretch for yield in an environment of low returns. This trend takes multiple forms, including expanded exposure to multi-sector credit portfolios, reassessing the role of nontraditional bond managers and resizing allocations to diverse global fixed income strategies. While this positioning may be desired, careful implementation is critical when assessing an increasingly diverse array of strategies to avoid leaving clients exposed to hidden risks.

The volatile start to 2016 was a reminder that a clear understanding of risk is paramount in an increasingly volatile environment. This can be challenging, especially in strategies that allocate across sectors with significant flexibility. Our proprietary tool, “MATADOR,” uses a rigorous analytical framework to help PIMCO’s clients understand the key risk factors embedded in their portfolios. Through a sophisticated regression algorithm, the tool estimates intuitive risk factor exposures for funds and portfolios based on historical returns. Armed with this knowledge, advisers are able to make more informed investment decisions across fixed income, equity, alternative and multi-asset portfolios.

Figure 1 shows the allocation of the average RIA client fixed income portfolio in our review. Core bonds continue to be the largest allocation as clients seek to preserve capital and diversify equity risk, albeit at lower levels of yield than they have enjoyed historically. However, advisers are using the next three biggest sectors – multi-sector, nontraditional and world bonds – to compensate for lower yields and generate higher return potential. The traditional benchmark-oriented spread strategies are next in size, including high yield bonds, bank loans, corporate bonds and emerging market bonds. Finally, smaller allocations provide liquidity, including short-term bond, short government and ultrashort bond.

RIA fixed income portfolios: More credit risk, less interest rate risk
While the asset allocation mix is important, an analysis of a portfolio’s risk factors¹ can provide a better understanding of how the portfolio may react to changes in markets. For example, it is not enough to know the market value allocation to Treasuries – the duration of that allocation is what will indicate the sensitivity to changes in interest rates. Similarly, it’s not enough to recognize that allocations to multi-sector and nontraditional bonds may have more credit risk than a core allocation. It is more important to understand what percentage of that risk is driven by high yield spreads compared with currency risk in emerging markets, for example, which can move in distinctly different ways. Insights like these are why PIMCO has managed portfolios with a focus on risk factors for more than 40 years.

For example, Figure 2 compares the risk allocation of the average RIA fixed income portfolio against that of the Barclays U.S. Aggregate. While the RIA portfolio experienced a similar level of realized volatility over the analysis period² , its credit risk through investment grade, high yield and emerging market currencies was higher. This may result in a higher yield and return potential for the average RIA fixed income portfolio, but also less diversification potential versus equities, an important consideration for overall portfolio construction. Additionally, despite the current rising rate environment in the U.S., a credit-oriented portfolio typically is more susceptible to drawdowns on a standalone basis given the traditionally higher volatility of credit and emerging market risks versus interest rate risk.

Risks more challenging to measure with traditional tools
Once aggregate portfolio risks are understood, often the focus turns to the sources of each risk. This is where careful analysis of the multi-sector bond, nontraditional bond and world bond managers becomes important. These categories have increased significantly in size over the past five years as investors have sought ways to increase yield and return potential while attempting to maintain some capital preservation and equity diversification potential. The more traditional “satellite” allocations of high yield, investment grade and emerging markets are still present as well, but have declined in prominence. However, when the risks of the multi-sector bond, nontraditional bond and world bond categories are decomposed, investors are still exposed to many of the same risks as presented by these traditional satellite allocations. The difference in these newer categories is that these risks may not always be as apparent or understood.

Figure 3 shows the top two managers by assets under management (AUM) across each of these different categories compared with the traditional satellite allocations. Even though two managers may fall under the same category, the approaches used are distinctly different in the multi-sector bond, nontraditional bond and world bond categories. These risks may be in line with investors’ expectations (and even desired), but it can be more challenging to discern them from allocation information alone. Interestingly, even in some traditional categories such as emerging market bonds, the risks may not be homogeneous across strategies. For example, the largest fund in the emerging market debt category is primarily exposed to emerging market local bonds, which carry significant currency risk, whereas the second-largest fund concentrates on U.S. dollar-denominated bonds, whose main risk is widening spreads.

Multi-sector. There are key differences in approaches. First, the range of opportunity sets is quite wide. Some funds are limited to a handful of fixed income sectors; others are managed to a broad range of fixed income sectors and some even include equities. These differences can significantly affect the yield generation potential and diversified nature of the risk. The second major difference is the goal and willingness of managers to balance income generation with capital preservation. While stretching for yield, some managers expose themselves to significant drawdown potential, especially during times of market stress (see Figure 4). Conversely, a low yield environment makes it difficult to generate an attractive yield while significantly limiting potential drawdowns. PIMCO favors a balanced approach; however, the role and use of multi-sector strategies will differ by investor.

Nontraditional. Typically, with broad mandates and flexibility, nontraditional bond approaches are even more varied than those of multi-sector bond strategies. To diversify U.S. interest rate risk and seek additional return, some managers focus on income generation through global credit markets, not unlike their multi-sector peers. Others have adopted more of a “global macro” approach that targets global rates and currency markets; some combine elements of both approaches. Note that a “strategic income” approach may concentrate the portfolio on a limited number of sectors and expose it to bouts of volatility as shown with Nontraditional Manager A (Figure 5). Other approaches, such as shown with Nontraditional Manager B (Figure 6), have proven more dynamic and diversified over time.


World Bond.
World bond managers differ most notably in the geography and currency denominations of their exposures. Managers within the same category may allocate their investments across a wide range of geographies in search of the best opportunities. Although a broad opportunity set is welcome, often strategies focus on a sub-set of countries with varying levels of exposure to the U.S., developed markets (ex U.S.) and emerging markets. Additionally, strategies range from fully unhedged to fully hedged. This is an important consideration since currency risk can be a large portion of a world bond strategy’s overall risk and change its diversification potential. For example, strategies with significant emerging market allocations may offer high yields and return potential, as shown with Manager E in Figure 7, but they may also be exposed to bouts of volatility and underperform in a risk-off environment, reducing their ability to diversify equity risk. In contrast, Manager D focuses its exposures on developed markets outside of the U.S. on a fully hedged basis. While yields may be lower, this manager is more likely to serve as an effective equity diversifier.

RIAs continue to face a challenging environment of lower return prospects and increased market volatility, making it difficult to construct well-diversified portfolios that meet their clients’ goals. It is more important in this environment to understand the true risks in your portfolio and ensure they align with your clients’ risk and return goals. We realize that is often not an easy task; hence, PIMCO offers RIAs customized portfolio reviews using proprietary analytic tools like MATADOR. Contact your PIMCO account manager for more information.




The Author

Kevin Winters

Alternatives Strategist

Justin Blesy

Asset Allocation Strategist

Ryan E. McMahon

Global Wealth Management



¹Risk factors are the underlying exposures within asset classes which justify a return premium and drive variations in returns. Examples of fixed income risk factors include duration (estimated portfolio movements to changes in interest rates) and credit spread duration (estimated portfolio movements to changes in credit spreads).

²5 December 2011 to 31 December 2015, representing maximum period of data availability.

All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Management risk is the risk that the investment techniques and risk analyses applied by PIMCO will not produce the desired results, and that certain policies or developments may affect the investment techniques available to PIMCO in connection with managing the strategy. Investors should consult their investment professional prior to making an investment decision.

This article contains hypothetical analysis and is being provided for illustrative purposes only. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Hypothetical or simulated performance results have several inherent limitations. Unlike an actual performance record, simulated results do not represent actual performance and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated performance results and the actual results subsequently achieved by any particular account, product or strategy. In addition, since trades have not actually been executed, simulated results cannot account for the impact of certain market risks such as lack of liquidity. There are numerous other factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results.

This material contains the current opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. It is not possible to invest directly in an unmanaged index. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2016, PIMCO