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Advisors are constantly on the lookout for more productive ways to navigate today’s volatile investment markets for their clients, especially in the fixed income market which has been experiencing a rather complex risk setting. As a cautionary warning, it is important to note that there is a major weakness with many traditional investment portfolios of treating “fixed income” as a single homogeneous asset class or category. Fixed income sectors are expansive, not all alike, and can react in their own way to external stimuli.
Understanding the differing nature of the various fixed income segments is crucial to managing risk and maximizing returns. Today’s investment environment very well may call for a tactical approach to fixed-income, with the ability to move between fixed income segments based on economic indicators and market opportunities.
To dig deeper and get a different perspective on these issues around managing risk and opportunity in the fixed income markets, we were introduced to Isaac Braley, President, Director, and Co-Portfolio Manager at BTS Asset Management – a Lincoln Massachusetts-based investment advisor that is known as one of the oldest risk managers and for utilizing traditional assets with a nontraditional approach. As we see more and more baby boomers heading towards retirement and increasing economic pressures on current retirees, there seems to be a growing attraction for risk-managed portfolio solutions.
Hortz: As tactical fixed income managers, you seem to characterize yourself more as “risk managers”. Can you share your thoughts about this distinction and how that guides and differentiates your asset management firm?
Braley: Our core investment philosophy is preservation of capital while providing the opportunity for growth within various asset classes, including equities, commodities, and fixed income. We believe there is a time to be in the market and a time to be out of the market, and we maintain a strong “sell” discipline, which is central to the preservation of capital philosophy.
From a behavioral perspective, studies show that the pain experienced from a loss is twice as powerful as the pleasure associated with a gain. And from a statistical perspective, large losses in a portfolio require even larger subsequent gains just to break even. For example, a portfolio that loses 40% must then return 67% in order to fully recover from that loss. These two ideas are what guide our emphasis on risk management.
Hortz: Why do you believe that most investors should not have a purely traditional fixed income strategy?
Braley: Two major things. First, not all bonds are created equal, yet traditional approaches tend to look at bonds as a homogenous asset class. Second, many bond strategies attempt to replicate the Bloomberg Aggregate Bond Index (Agg) performance, which represents only a portion of the fixed income opportunities available in the market. The index excludes tax-exempt municipals, inflation-linked bonds, floating rates, convertibles, and, most notably, high-yield bonds.
I’ll speak to the variation among bonds first. Fixed income sectors tend to get mistakenly lumped into one bond category. No matter the market’s general direction, many bond sectors perform differently from each other, exposing potential opportunities. For example, high-yield bonds and U.S. Government bonds have historically shown very low correlation to one another, often moving in opposite directions. We believe there is a need for tactical management to take advantage of these market trends and attempt to be in the “right bond at the right time.”
Secondly, we believe investors are missing out on many areas of opportunity in the fixed income space by looking at the Agg as a representation of the entire bond market. In reality, the Agg is heavily weighted toward U.S. government exposure, with nearly 75% of the index being made up of U.S. Treasuries, government agency debt, and mortgage-backed securities. While we invest in these parts of the bond market, we also believe in finding fixed income opportunities in areas not included in the Agg.
Hortz: Can you explain how you constructed your fixed income portfolios to specifically address the above issues?
Braley: Our Tactical Fixed Income strategy, wherein we make up to 100% moves between high-yields, treasuries, and cash, was constructed to take advantage of the low-to-negative correlation between high-yield bonds and treasuries. High-yields tend to be more correlated with the equity market, and thus present opportunities in bull markets and recoveries. When risks show up in the equity market, investors tend to prioritize safety, and this “flight-to-quality” often creates attractive opportunities in the treasury space. And if there isn’t a clear trend in either direction, sometimes it is best for us to move to cash, preserving capital and waiting for a new trend to develop. Although high-yield bonds correlate to the equity markets, they have historically moved at a slower rate, allowing an opportunity for tactical management. We believe the equity markets move too quickly to deploy a similar tactical approach.
On the other hand, our Managed Income strategy was partly constructed to address the Agg’s incomplete nature. The core of the strategy is broken down into two distinct buckets. The “Risk-Off” portion will look very much like the Agg, holding things like treasuries, agency bonds, and mortgage-backed securities. Even though we may hold similar investments to the Agg in this portion of the portfolio, we will adjust security allocations and maturities to where we believe the most attractive investments are. Another area of differentiation from the Agg is in the “Risk-On” side of the portfolio, where we use a wide variety of income-producing asset classes that you would not typically find in an Agg-based fixed income strategy. These include high-yields, convertibles, international bonds, and even income-focused equity strategies such as covered call portfolios. We can then adjust the weightings between the “Risk-On” and “Risk-Off” sides of the portfolio to take advantage of changing market conditions.
Hortz: What are your thoughts on how the Fed is handling our current challenges?
Braley: Our view is that the Fed has been behind the eight ball in responding to recent challenges. While the early stages of the pandemic required drastic intervention to avoid financial disaster, we believe those policies were maintained for far too long, allowing severe inflation to take hold. Once they finally abandoned the idea that inflation was transitory and would take care of itself, they had to pivot strongly in the other direction, adopting a restrictive policy that appears to have been too tight too fast.
With the recent bank failures, we are starting to see some of the ramifications of these overly reactive policies. I have seen too often the Fed come too late and aggressive in their policy decisions. They need to stop inflation, but there are consequences for policy decisions this late in the game.
Hortz: So, for the big question – what are your thoughts as to if we are going to have a hard or soft landing? How are you preparing in your portfolios?
Braley: Today’s markets are especially difficult to get a clear picture of. Those making a bull case may point to the continued resiliency of the consumer and the strength of the job market. But those predicting a hard landing have plenty of evidence to support their case as well, from yield curve inversions to warning signs appearing in popular predictive models such as the Leading Economic Indicators Index. And those in the middle of those two extremes can combine arguments from both sides to conclude that a soft landing will be achieved.
At this point in the economic cycle, we have found the consumer beginning to pick up substantial amounts of revolving debt to continue the spending spree. How long this can last is the central question. It is vital for us to remember that it is not how much a product or service costs at the time of the transaction but what the final cost is when it is paid for. You may see lower prices at the gas pump, but if that debt is not paid off for a year, you could have a significant inflation scenario. Many consumers may believe that the Government will just bail them out again, as we have seen in recent years, but this will eventually lead to a hard landing scenario.
In any event, we have portfolio solutions designed to take advantage of prevailing market conditions. In the event of a hard landing, our Tactical Fixed Income portfolio can move 100% to cash to preserve capital, or 100% to treasuries to participate in a “flight-to-quality”. These tools have served the portfolio well during past major market selloffs, such as the early 2000s, 2008, and 2020.
Our Managed Income portfolio is better suited to a soft-landing scenario. This portfolio isn’t designed to completely avoid a major selloff like the tactical strategy is, but it is highly diversified and has several risk-management tools embedded in its design that may allow it to avoid a portion of a selloff while remaining invested and ready to participate in the subsequent market recovery.
Hortz: Can you share any key recommendations or advice for advisors in managing their clients fixed income portfolios in today’s challenging investment environment?
Braley: The two most important aspects of our investment philosophy, in any environment, are capital preservation and the idea that not all bonds are created equal. When thinking about capital preservation, we recommend prioritizing risk management, understanding the different types of risk (interest-rate risk, default risk, etc.) and how they affect different asset classes, and understanding that one of the best ways to make money is to avoid losing it. And when approaching fixed income, investors who want to take advantage of every opportunity available to them should stop thinking of the bond market as a homogenous asset class that is represented fully by the Agg.
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