Boost Bond Portfolio Returns With Alternative Fixed Income Sectors

When investors seek portfolio diversification, they typically turn their attention to the equity market, probing for an over concentration of risk in a particular geography or sector. However, diversification is just as vital in the bond market, where many investors primarily concentrate on “core bond” portfolios composed of government bonds, agency mortgage-backed securities, and investment-grade corporate bonds. Despite their popularity, these portfolios may lack sufficient diversification.

Disappointing returns of core fixed-income last year highlight the need for an alternative approach to gaining exposure to the asset class. The iShares Core U.S. Aggregate Bond ETF (AGG
AGG
) shed more than 13% in 2022, the worst total return in decades, surprising investors with additional losses on top of the pain they experienced in their equity portfolios.

Traditional core allocations, such as those to the Bloomberg Barclays Aggregate Index, overlook substantial segments of the bond market, including inflation bonds, high yield bonds, bank loans, municipal bonds, non-agency mortgages, and most structured credit products. By incorporating exposure to some of these sectors, investors can enhance yield in their bond portfolios without significantly increasing credit risk or interest rate risk.

Two notable examples are AAA-rated collateralized loan obligations (CLOs) and AAA non-agency mortgage-backed securities, both of which offer relatively high yields and diversification benefits, thereby enhancing the risk-reward profile and potential returns of bond portfolios.

Collateralized Loan Obligations (CLOs)

CLOs are a type of securitized product created with pools of senior-secured corporate loans. These loans, individually, do not carry an investment-grade credit rating, but when their cash flows are repackaged into separate tranches, risk can be dispersed across the credit spectrum, from AAA bonds down to single-B bonds.

CLOs offer higher yields compared to traditional bonds, making them attractive to income-seeking investors. Moreover, due to their floating-rate nature, CLOs are relatively resistant to interest rate fluctuations, adjusting to prevailing market conditions. For instance, AAA CLOs yield around 6.25%, compared to the 5.48% current yield on the Bloomberg Barclays Aggregate Index.

While adding CLOs to a bond portfolio will reduce interest rate exposure, it will add illiquidity risk. CLOs tend to underperform in times of market distress, partially due to their lower liquidity, but also because their sensitivity to overall credit conditions. Higher yields are the compensation for these risks.

Investors have various avenues to enter the CLO market. For example, AAA CLO ETFs are available from Blackrock (CLOA) and Janus Henderson (JAAA). For those willing to venture further down the credit spectrum, VanEck offers an ETF (CLOI) that includes AAA, AA, and A-rated CLOs.

Non-Agency Mortgage-Backed Securities

Non-agency Mortgage-Backed Securities (MBS) represent another asset class that can amplify diversification within bond portfolios. Unlike agency MBS, backed by government-sponsored entities, non-agency MBS comprise residential mortgage loans that do not meet the requirements for agency backing, such as jumbo mortgages.

A jumbo mortgage is a home loan that surpasses the conforming loan limits set by government-sponsored enterprises (GSEs) like Fannie Mae
FNMA
and Freddie Mac. Primarily used to finance high-value properties, jumbo mortgages often demand a higher credit rating compared to regular mortgages. Relative to agency mortgages, AAA-rated jumbo MBS offer roughly 40 bps of extra option-adjusted spread.

The price of non-agency mortgages will track the agency MBS market quite closely. Similar to other fixed-rate, prepayable mortgages, they will do better in when interest rate volatility is declining. Adding these securities to a bond portfolio should not materially alter the risk.

The most effective way for investors to gain exposure to non-agency MBS is via fixed income mutual funds targeting the mortgage sector. One such example is the PIMCO Income Fund (PIMIX), which boasts more than 120 billion in assets. As per its latest quarterly filing on March 31, the fund had an allocation of 33% to non-agency mortgages.

The Importance of Diversification

Similar to equities, diversification in bond portfolios is crucial for managing risk and optimizing returns. By including alternative bond sectors like CLOs and non-agency MBS, investors can explore diverse risk-reward profiles and diminish sensitivity to interest rate movements.

Given that bond yields are now higher and offer better income-generating potential than most of the past decade, investors should consider broadening their exposure to the asset class beyond traditional core bond portfolios. The bond universe is much larger than just governments, agency MBS and investment-grade corporate bonds.