3. Add in Nontraditional Bond Sectors
You may find that the confines of mortgages, Treasuries and corporates are just too narrow to meet your objectives without overconcentrating the portfolio in any one sector. In these types of situations, ancillary bond segments can provide potential diversification and income benefits.
Bond segments like senior loans, high yield and emerging market debt are historically less correlated to the Agg.1 When assets are less correlated with each other, their prices tend to diverge, offering the potential for greater diversification and thus, reduced risk. As such, incorporating these bond segments can potentially help boost a portfolio's risk/return profile.
The hypothetical example below allocates 30% of the core fixed income portfolio to complements, while maintaining a 70% weighting to the optimized Agg exposure shown in the previous example. As illustrated, this would result in an improved yield/duration profile, without overconcentration in any singular complement exposure.
Following a rules-based approach like this leads to a portfolio with 157% higher yield per unit of duration than the Agg and increased diversification across geographies and sectors, all while not taking on significant spread risk, as the overall credit spread level is commensurate to investment grade corporate bonds. And as for diversification, the Bloomberg Fixed Income risk model shows that this portfolio has a lower expected standard deviation than the broader Agg-1.4%, versus 3.1%-all due to the balanced nature of credit and interest rate risks within this more expansive portfolio that goes beyond a simple mix of high-grade corporates and Treasuries.