Delivering positive real returns to bond fund shareholders now requires a more creative way of thinking — one that more actively assesses sector and issue-specific risks, says Scott Kimball, portfolio manager for BMO TCH Corporate Income and Core Plus Bond Funds.

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Kimball notes that few asset classes have evolved more than fixed income, enabling investors to create a highly customized allocation for a wide range of objectives. However, as the exposure to non-traditional fixed income increases, the impact on a plan’s total risk profile may change materially.

But “like any asset class, there is no way to de-risk fixed income entirely,” says Kimball. “We can only shift away from risks that appear undesirable to those deemed more manageable.”

According to Kimball, a low-yield, negative real interest rate environment raises investor concerns about interest rates and inflation. To offset these concerns, investors are increasing their exposure to other risks such as credit and liquidity. As exposure to these risks increases, the correlation between fixed income and other asset classes (such as equity) may increase, thereby lowering the diversification benefits of a fixed income allocation.

AUDIO: Expect lower fixed-income returns

Referred to as contagion risk, the decrease in diversification often occurs during periods of stress throughout financial markets, which is the most inopportune time.

Kimball notes that, historically, timing interest rate cycles has been difficult and costly because lowering duration greatly reduces the diversification benefits of fixed income. As the majority of fixed income investors continue their quest for higher yields, it is unlikely these gains are free on a risk-adjusted basis.

Specifically, increases in yield are accompanied by additional credit and/or liquidity risks. After adjusting for the change in risk, such as increased volatility, excess yield is usually low.

“The 30-year bull market in bonds — which has been driven by ever-lower interest rates — is coming to an end,” he says. “In today’s low-yield, negative real interest rate environment, it’s very difficult to deliver positive returns to our bond fund investors by traditional ways such as clipping coupons and making wholesale maturity and duration decisions. We have to look elsewhere — to positioning along the yield curve, to lower-quality credits, to inflation-protected treasuries and beyond. It means looking outside of the ubiquitous benchmark and understanding the potential risks.”

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