Rethinking fixed-income investing: an alternative approach

The pace at which the macro environment is evolving can be seen in the speed at which rate-cut expectations has changed in the past 12 months. Amid such uncertainty, it may make sense to assess if the traditional approach to fixed-income investing alone is enough to help investors meet their financial goals.

Fixed-income investing: a challenging few years

No amount of window dressing can disguise the fact that, prior to last year, returns haven’t been great for fixed-income investors.

While few could have predicted at the start of 2022 that the U.S. Federal Reserve (Fed) was about to embark on its most aggressive rate-hike cycle in decades, the enduring strength of the U.S. economy has also made it difficult for anyone to pinpoint precisely when the U.S. central bank might start easing. Although the bond market did finish 2023 on a positive note, its performance paled relative to equities and, significantly, within the context of a portfolio.

2023 was a positive year for fixed income, but returns paled relative to equities
Simple bar chart comparing total returns in 2023 between stocks and bonds in the United States and Canada, using widely followed indexes. The chart shows that while fixed-income assets delivered positive returns in both markets in 2023, the returns were noticeably lower than the returns for equities in both markets.

Source: Manulife Investment Management, Bloomberg, as of December 31, 2023. Total returns are shown in local currency or in USD for multimarket indexes.

Portfolio diversification remains important

Tempting as it may be to simply allocate less to fixed income, seasoned investors understand why that isn’t the best way forward. Diversification may seem less essential amid a so-called everything rally—when investors are likely to receive positive returns regardless of which asset class they’ve invested in—but what happens when it ends? History has shown us that traditional correlations between asset classes tend to assert themselves when these rallies fade. 

Bond market volatility remains elevated
Simple line chart of the Intercontinental Exchange Bank of America U.S. Bond Market Option Volatility Estimate (MOVE) Index from April 2004 to data available as of April 24, 2024. The chart shows that bond market volatility remained elevated.

Source: Macrobond, Manulife Investment Management, as of April 24, 2024. The Intercontinental Exchange Bank of America (ICE BofA) U.S. Bond Market Option Volatility Estimate (MOVE) Index tracks fixed-income market volatility. It is not possible to invest directly in an index.

The answer, in our view, lies in rethinking the way we approach fixed-income investing and how it’s used in our portfolios. Against the current macroeconomic backdrop, we believe it makes sense for investors to consider alternative fixed-income strategies as a driver of portfolio returns to complement their current allocation.

How are alternative fixed-income strategies different from their traditional peers?

By default, alternative fixed-income strategies are designed to deliver higher returns―and in some cases better yield―than their traditional peers while maintaining a similar or slightly lower level of risk.

At the risk of oversimplifying things, it’s fair to say that these strategies are able to offer a more desirable risk/return profile because they can access a much wider set of investment tools—including credit default swaps, interest-rate swaps, and other derivatives—relative to their traditional peers.

This helps the investment teams behind these strategies in two important ways:

  1. It enables them to further their pursuit of their desired goal, whether it be higher alpha or to enhance yield; for instance, lengthening or shortening duration to an extent they wouldn’t have been allowed to otherwise and investing in assets such as private loans or asset-backed securities that they couldn’t before. 
  2. Their access to derivatives enables them to manage the overall risk the portfolio is exposed to in a targeted way; for example, using derivatives to take a short position in a government bond against a corporate debt issue of the same maturity.

Crucially, these tools also bring about additional flexibility that enables investment teams to pursue tactical opportunities in a timely manner. 

Here’s an analogy that might explain the concept better: If traditional fixed-income strategies were basic soundbars that played music in stereo, alternative fixed-income strategies would be like their more sophisticated cousins that allow you to adjust the level of bass, mid, and treble to create a more dynamic sound stage without destroying your eardrums. It’s all about having access to the individual levers that enable users to control what they hear.

Naturally, it isn’t just about pursuing opportunities. These tools can also be used to dial down risks; specifically, those that are closely associated with fixed-income investing: interest-rate, credit, duration, and liquidity risk. 

"Against the current macroeconomic backdrop, we believe it makes sense for investors to consider alternative fixed-income strategies as a driver of portfolio returns to complement their current allocation."

Know what you’re investing in and who you’re partnering with

While alternative fixed-income strategies may sound appealing, they’re complex investment products relative to traditional bond funds and, as such, may not be suitable for everyone. These strategies’ origins, which can be partially traced to hedge funds, have also bestowed on them the reputation of—rightly or wrongly—being impenetrable black box operations. In our view, it’s important for investors to have a thorough understanding of what they’re investing in and who they’re partnering up with. It also must be said that there are many different types of alternative fixed-income strategies in the market that could potentially be used to serve a different purpose in a typical portfolio, and care should be taken to ensure that an investor’s goals, risk tolerance, and investment time horizon are aligned. 

Alternative fixed income could make sense in the current environment

The current macroeconomic outlook remains uncertain. It’s unclear whether the U.S. economy will slip into a recession soon, setting the stage for a rebound later this year, or if it will progress on its current path only to amplify risks of a bigger slowdown next year. Uncertainty is building, along with the likelihood of policy errors. In this environment, we believe it makes sense for investors to rethink their approach to bonds and consider complementing their fixed-income allocations with strategies that are, shall we say, a little less traditional. 

The information in this material, including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.

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Kevin Headland, CIM

Kevin Headland, CIM, 

Co-Chief Investment Strategist

Manulife Investment Management

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Macan Nia, CFA

Macan Nia, CFA, 

Co-Chief Investment Strategist

Manulife Investment Management

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