Heading into 2016, many Registered Investment Advisers (RIAs) continued a strategy in fixed income that had worked quite well since the financial crisis: overweighting credit and other higher-yielding sectors in search of higher returns. However, volatility in the first weeks of 2016 quickly drove high yield spreads almost 300 basis points (bps) higher, while U.S. 10-year Treasury bonds rallied by 70 bps.1 Reacting to this risk-off environment, investors collectively reallocated more than $100 billion to core bond funds and more than $20 billion to short-term and ultra-short bond funds over the first 10 months of 2016 ‒ representing more than 70% of the year’s net bond fund flows2 ‒ only to have the U.S. election results in November spur a Treasury bond sell-off that drove yields almost 80 bps higher. These events, coupled with PIMCO’s outlook for increased volatility over the cyclical horizon, are a reminder of the importance of understanding the key risks driving fixed income portfolio performance.

If fund flows alone tell the tale, many fixed income investors were whipsawed by the events of 2016.

In our view, the sudden turnabouts are not over. PIMCO’s current outlook for 2017 includes an increased likelihood of lower returns and higher volatility. In addition to this difficult investment environment, many RIAs are facing portfolio construction challenges that depend on understanding and quantifying risk:

  • Sources of risk in their portfolios
  • Individual manager risks and how they have changed over time
  • The impact of potential allocation changes on their portfolios

At PIMCO, we regularly conduct customized portfolio analyses for clients using our proprietary tool MATADOR. Based on our review of 110 RIA portfolios in 2016, we can provide insight into these three portfolio construction challenges in light of the current investment environment and considerations as advisers look ahead to 2017.

Portfolio risks

To start with an overall picture of fixed income portfolio risk, Figure 1 shows the average allocations by Morningstar category of PIMCO RIA clients based on a portfolio analysis in 2015 and 2016. In 2016’s average allocation, there was a noticeable increase in intermediate- and short-term bond allocations compared with 2015 and corresponding decreases in nontraditional bond exposures, in line with broader industry flows.

We used our proprietary analysis tool, MATADOR, to extract the 2016 average portfolio risk factors, shown in Figure 2, to provide a much clearer understanding of how the portfolio may react to changes in the markets. Compared with the Bloomberg Barclays U.S. Aggregate Index, the average RIA client portfolio analyzed by PIMCO is more diversified across sources of risk, with a similar level of volatility. However, the average client RIA portfolio analyzed is also more exposed to credit and emerging markets (although these risks were marginally lower in 2016 than in 2015).

MATADOR

PIMCO’s MATADOR tool uses a rigorous analytical framework to help 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.

To find out how the average RIA client portfolio analyzed by PIMCO might react to changes in yields and spreads, we used MATADOR to estimate the portfolio’s average factor exposures – specifically, duration and credit spread duration. We found that the average RIA portfolio analyzed in 2016 had a duration of 2.8 years whereas the Bloomberg Barclays U.S. Aggregate Index had an estimated duration of 4.1 years. All else equal, for every 100 bps increase in the U.S. 10-year Treasury yield, the average RIA portfolio’s value would decline by 2.8%. These factor exposures are a nice complement to the portfolio risk decomposition and can help anticipate the portfolio’s reaction to changes in the market.

Risks associated with individual managers

Identifying differences in risk across managers and how they may affect an overall portfolio is a particularly useful analysis. While these differences are often apparent in highly active funds, the comparison can also be helpful in categories where investors are increasingly using passive strategies. We reviewed two of these categories in detail, intermediate-term core bond and short-term bond, using MATADOR.

First, we compared the risk and return profiles of the largest short-term funds. As shown in the risk decomposition in Figure 3, the funds with the lowest yields generally tend to have risk concentrated in short-term duration. Most actively managed short-term funds add some high quality credit to complement the passive interest rate exposure in short-term government and agency securities and add potential return. While too much credit risk can introduce unwanted volatility, especially during equity market/risk asset sell-offs, the appropriate amount can help drive a meaningful return difference in short-term allocations. Additionally, short-term funds are most directly affected by increases in the Federal Reserve’s policy rate, so allocating passively in these funds can result in not only lower return potential but also limited flexibility to mitigate the risks stemming from policy rate increases.

Similarly, in core bonds, the risk in the passive funds we analyzed was largely concentrated in duration, whereas active funds often mix in other types of risk, including credit, mortgage and currency risks, as shown in Figure 4. These additional sector exposures can help active managers navigate changes in interest rates and also potentially generate additional return, which is particularly important today. For example, the yield of the Bloomberg Barclays U.S. Aggregate Index has decreased to near all-time lows, but its duration risk has increased approximately 20% since the financial crisis. During the recent increase in bond yields from July through December 2016, the Barclays U.S. Aggregate returned ‒3.3%, matched by the average of the 10 largest passive managers who also returned ‒3.3% while the 10 largest active managers outperformed by approximately 100 bps.

Impact of changing allocations within a portfolio

When allocating risk in portfolios, it is important to size allocations appropriately in the current environment. For example, there are multiple ways to add duration (at the short, intermediate or long end of the yield curve), with varying effects on a portfolio’s overall risk profile. As Figure 5 shows, the Bloomberg Barclays 1-3 Year Government/Credit, Bloomberg Barclays U.S. Aggregate and Bloomberg Barclays Long Treasury Indexes have significant differences in their total volatility, duration and yield curve positioning.

Furthermore, the marginal impact of a change in risk allocation on the portfolio can be significant – a 25% increase in short-term strategies, for example, would have reduced total volatility in the average RIA portfolio analyzed by 20% and placed more of the portfolio’s risk at the front end of the yield curve, whereas adding 25% in long-term Treasuries nearly would have doubled the portfolio’s volatility and concentrated almost all of the portfolio’s risk in duration. As shown in Figure 6, these examples illustrate the importance of quantifying the impact of potential portfolio changes to ensure the desired effect on the portfolio’s risk profile.

Conclusion

While market volatility early in 2017 remains low, the events of 2016 and PIMCO’s outlook for increased tail risks over the secular horizon make it an important time to get a deeper understanding of your portfolio and manager risks. This is often not an easy task, which is why we offer RIA clients customized portfolio reviews using proprietary analytic tools like MATADOR. Contact your PIMCO account manager for more information.

1 High yield represented by the Bloomberg Barclays U.S. High Yield Index.
2 Source: Morningstar


The Author

Kevin Winters

Account Manager, Global Wealth Management

Justin Blesy

Asset Allocation Strategist

Ryan E. McMahon

Global Wealth Management

Related

Disclosures

Past performance is not a guarantee or a reliable indicator of future results.

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. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.

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.

There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. 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.

The portfolio analysis is based on a sample portfolio and index blends. No representation is being made that the structure of the average portfolio or any account will remain the same or that similar returns will be achieved. Results shown may not be attained and should not be construed as the only possibilities that exist. Different weightings in the asset allocation illustration will produce different results. Actual results will vary and are subject to change with market conditions. There is no guarantee that results will be achieved. No fees or expenses were included in the estimated results and distribution. The scenarios assume a set of assumptions that may, individually or collectively, not develop over time. The analysis reflected in this information is based upon data at time of analysis. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.

PIMCO routinely reviews, modifies, and adds risk factors to its proprietary models. Due to the dynamic nature of factors affecting markets, there is no guarantee that simulations will capture all relevant risk factors or that the implementation of any resulting solutions will protect against loss. All investments contain risk and may lose value. Simulated risk analysis contains inherent limitations and is generally prepared with the benefit of hindsight. Realized losses may be larger than predicted by a given model due to additional factors that cannot be accurately forecasted or incorporated into a model based on historical or assumed data.

It is not possible to invest directly in an unmanaged index.

This material contains the current opinions of the authors but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

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