The Omicron variant and the looming threat of rising rates have unsettled markets. In addition, the economy is now facing both monetary and fiscal tightening in 2022. These risks coming at a time when Treasury yields are low and credit spreads are narrow suggests that the first half of 2022 could be progressively more turbulent.
So, during this turbulent market environment, flexibility and a collaborative multi‑sector approach are essential components of fixed income portfolio management, according to a recent white paper issued by T. Rowe Price.
According to the paper, written by T. Rowe Price Total Return ETF (TOTR) portfolio managers Chris Brown and Anna Dreyer, credit fundamentals are still strong and market technicals are supportive, despite the above-mentioned headwinds.
“Our flexible, active portfolio management approach should give us opportunities to take advantage of anomalies that are present in this unusual environment — as well as inefficiencies that tend to persist regardless of the macro backdrop — while managing risk in the Total Return Fund,” the authors of the paper write.
Amidst ongoing uncertainty and market volatility, TOTR’s managers plan to keep the portfolio defensively positioned, while still selectively adding exposure to fixed income sectors that provide relatively attractive valuations, such as some areas of securitized credit and bank loans, which have floating coupons that would adjust upward as the Fed raises rates.
T. Rowe Price argues that a “multi‑sector portfolio management approach allows the freedom for relative value comparisons across fixed income sectors.” For example, investment‑grade corporate bonds and similarly rated municipal bonds or asset‑backed securities often trade differently.
Plus, bond markets are more fragmented than equity markets and tend to have investors that are narrowly focused on a sector or asset class niche. This can result in disparate cross‑sector relative value. So, a multi‑sector approach can capitalize on these relative value dislocations.
In addition to building portfolios that diversify credit risk across sectors, the paper argues that using this multi-sector approach also allows TOTR’s managers to make tactical allocation adjustments when they identify possible relative value opportunities, such as out‑of‑benchmark allocations to high-yield bonds and bank loans.
Having the flexibility to adjust duration is also essential in a volatile environment. At the end last year, overall duration in TOTR “was close to the benchmark with a slight bias toward a short relative duration position,” according to the paper. When U.S. economic growth was hastening in early 2021, the fund’s managers maintained a shorter‑than‑benchmark-duration position, which helped mute the negative price effects of increasing yields.
Fixed income markets also feature structural inefficiencies that endure even though many market participants understand them. Most of these inefficiencies come from imbalances between supply and demand or from investor constraints. These areas where such structural inefficiencies can be found include shorter-maturity investment-grade corporate bonds, credit derivatives, non‑investment‑grade securities, and securitized credit.
“Our quantitative research team has identified some of these anomalies and tested their robustness in various macro scenarios,” the paper states. “As long as we have a relatively high degree of confidence that these inefficiencies will persist in the longer term and that they are appropriate for our investor base, we try to take advantage of them.”
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