A new white paper from Columbia Threadneedle Investments explores how applying a full understanding of the four unique, major fixed income risks to a portfolio—duration, currency, credit and inflation—may yield a better risk/return outcome.
The white paper, “When Can Risk Mean Opportunity? Harnessing Fixed Income Returns Through the Cycle,” illustrates how a multi-sector fixed income portfolio based on the four risks may succeed where some binary risk allocation strategies are presently failing.
“We believe that understanding the four risk factors lays the foundation for successful, strategic bond market investing,” the white paper states. “Because these factors are not highly correlated, they can provide diversification benefits in a portfolio when used together.”
Authors Gene Tannuzzo, CFA, Deputy Global Head of Fixed Income and Gordon Bowers III, CFA, Associate Research Analyst, share how today’s investors can gain a better understanding of the factors that generate risk and return by breaking bonds down to their most basic components. A better understanding of these drivers can help investors navigate the current market and build bond portfolios that can generate attractive returns through the cycle.
The white paper defines the four dominant risk factors as such:
- Duration or interest rate risk, represents the price volatility of a long-term investment as prevailing market interest rates change.
- Currency risk is driven by fluctuations in exchange rates.
- Credit risk represents the risk of default for lending to a private corporation, consumer or risky sovereign country.
- Inflation risk is driven by actual and expected changes in consumer prices.
The white paper then breaks down each of the four dominant risk factors in detail, revealing when each risk factor is most and least attractive in terms of providing positive return potential.
“Since each risk factor is unique, they produce positive returns in different periods throughout market cycles, creating opportunities for investors to emphasize different risks at different times and in different market environments,” the white paper states.
Even though low yields and interest rate uncertainty make the current fixed-income environment challenging, most investors still need bonds in their portfolios. When allocating to fixed income, the authors say the best starting point is selecting the risk factors to which an investor wants exposure and then choosing the appropriate alpha sources.
In particular, investors should seek opportunities presented by bond market risk factors beyond duration. “Today’s bond market offers profitable total return opportunities for investors who are able to allocate their risk budgets efficiently,” the white paper states.
While basing fixed-income allocation on the four risks is an important first step, the white paper concludes with advanced risk balancing strategies that may be required to optimize a portfolio.
Veteran financial services industry journalist Brian Anderson joined 401(k) Specialist as Managing Editor in January 2019. He has led editorial content for a variety of well-known properties including Insurance Forums, Life Insurance Selling, National Underwriter Life & Health, and Senior Market Advisor. He has always maintained a focus on providing readers with timely, useful information intended to help them build their business.