In today’s environment of rising economic uncertainty, our conversations with clients often include questions about minimizing risk without losing income-generating potential. This is a careful balance and one that we are increasingly addressing with an infusion of strategic income products into the fixed income portfolios that we manage. Calculated and actively managed use of these non-traditional fixed income asset classes may be an effective strategy to enhance returns while maintaining stability in a portfolio and potentially lowering risk as well.
Understanding Strategic Income
Many are familiar with the traditional fixed income asset classes, which include municipal bonds, investment-grade corporate bonds and treasury or agency securities. However, we find that non-traditional fixed income securities are often overlooked or misunderstood by investors. These strategic income securities include preferred stocks, collateralized loan obligations (CLOs), mortgage-backed securities (MBS), bank loans and high-yield bonds. These securities also represent a significantly smaller portion of the fixed income market and therefore do not get as much attention because of their size.
Ancora’s fixed income team sees this asset class as an opportunity to enhance the returns of a fixed income portfolio, though there are a few things to note. When incorporating strategic income, we believe this exposure should take place within an actively managed bond portfolio. This allows the portfolio managers to adequately diversify and adapt the portfolio to changing market conditions and economic cycles, which in turn may allow the portfolio to be more resilient and optimized for income generation.
The Role of Strategic Income in a Bond Portfolio
To explore the opportunities that strategic income securities may present, we first look at how they have performed over the past several years. The following illustration of fixed income returns shows how strategic income asset classes, shaded with stripes, have outperformed the broader bond market, represented by the Bloomberg US Aggregate Bond Index.
Depending on an investor’s risk tolerance and circumstances, we will typically recommend a strategic income allocation of between 10-30% of their overall fixed income allocation, which we then adjust over time for changing risk tolerance and economic conditions. Used in this way, we have seen strategic income securities provide diversification, income generation and risk management to fixed income portfolios, as described below.
- Diversification: Strategic income funds often invest across multiple categories, adding exposure to non-traditional asset classes that can have lower correlations to the traditional bond market. This broad diversification may help reduce the overall risk of a portfolio.
- Income Generation: Strategic income securities typically provide a higher level of current income compared to traditional fixed income asset classes. Some strategic income securities, such as preferred stocks, can also provide a tax advantage for taxable accounts.
- Risk Management: Actively managing the duration and credit quality of fixed income exposure, including strategic income exposure, helps mitigate risks associated with interest rate fluctuations and credit defaults.
- Flexibility: Adding strategic income securities to a portfolio allows the investor to take advantage of potential dislocation in non-traditional fixed income asset classes.
Our fixed income team believes incorporating strategic income securities into a bond portfolio is a balanced approach that may achieve a higher level of income and portfolio diversification, while at the same time reducing overall risk of the portfolio. Our team considers a variety of factors when building a portfolio of individual securities including credit quality, duration and the specific characteristics of the strategic income exposure, as well as the investor’s risk tolerance and needs. Please consult your advisor for additional information.