Unconstrained fixed income: Harnessing the diversity of the universe
Fixed income as an asset class goes well beyond notions of low risk and low return. Today’s global fixed income universe comprises a broad spectrum of sub-classes with the potential to deliver outcomes ranging from capital protection to income and capital growth. An unconstrained approach can aim to access this range of opportunities, rather than being limited to a particular area of the universe.
In our view, most investors look to unconstrained fixed income strategies to deliver attractive risk-adjusted returns through the market cycle. We believe the key to achieving this is actively managing a portfolio of different types of risk factors. In managing an unconstrained fixed income strategy, our focus is on constructing a portfolio which is structurally diversified, liquid and exposed to high conviction single name ideas.
Maintaining an appropriate balance
Risk management is an integral part of our asset allocation approach. We aim to manage the portfolio in a prudent and responsible fashion because we think that most investors are not looking for their bond allocation to be the most aggressive segment of their total portfolio.
However, that is not to say we don’t have a high conviction strategy. We strongly believe in creating potentially good returns by using the flexibility to be opportunity-driven and selective rather than tied to a specific benchmark. We also prefer to emphasize on implementing active strategies and single name ideas that are conviction-driven and designed to weather short-term noise, rather than trying to aggressively time markets.
We know the economic cycle is in constant motion and different asset types will perform better or worse at different points. This does not make asset allocation as easy as it sounds. Firstly, we need to be able to identify where we are in the cycle to get ahead of the market and obtain the right assets at the right price. Secondly, hugely unpredictable market events can happen at any point.
Managing an unconstrained fixed income strategy through a changing market environment is not about predicting the unpredictable. Rather, it is about positioning for the right, long-term reasons based on observable facts - and having the agility to respond as markets move.
Simplicity and transparency
Unconstrained fixed income is a broad concept and strategies can vary in complexity and objectives. Some areas of today’s fixed income universe are more complicated and exotic than traditional bonds. While these can offer compelling yields and perform well in risk-on phases, being overly concentrated in these areas may expose investors to more risk than they anticipate.
So, investors should always know what’s ‘under the bonnet’ of any strategy they choose. At AXA IM, we prefer simplicity and transparency to mitigate negative surprises. This reflects our central philosophy that investors do not want their core fixed income portfolio to be too aggressive but rather prefer to aim for optimised total returns while avoiding the worst of the lows, through the cycle.
At AXA IM’s unconstrained fixed income team, we rely on the engines of expertise we have around the world in terms of our extensive global resources to generate ideas across the fixed income spectrum and then apply a proprietary framework which allows us to filter that spectrum in a different way.
This framework breaks the universe down into three categories of sub-asset types and allocates between them taking account of prevailing economic and market conditions and valuations.
The first category is Defensive. Defensive assets would be the highest rated, most liquid, purely interest rate-sensitive assets, so, mainstream government bonds.
The next category is Intermediate assets. These are high-quality, investment grade credit. Qualitatively, we would include peripheral-European government bonds as there is currently credit spread in those assets.
Lastly, what we call our Aggressive assets. These are what we consider somewhat equity-like. They are high yield and emerging markets (whether they be emerging market sovereigns, investment grade or high yield). For simplicity’s sake we define aggressive assets as those that have those that have most credit risk or default risk.
Fig.1: A simple way to approach asset allocation through the cycle
Source: AXA IM. Defensive / Intermediate / Aggressive in the context of AXA IM’s proprietary unconstrained fixed income framework. The descriptions above represent our strategic approach only.
Above all, we are confident that the structural diversification in the framework minimises volatility relative to any of the individual sources of risk from credit or rates. Our framework relies on understanding correlations between different fixed income assets, duration and credit ratings, as well as the notion of negative correlation between pure rate risk (duration) and pure credit risk (excess return). The skill of our investment team is in understanding how to balance our positioning tactically across this very broad spectrum, throughout the market cycle.