Morningstar - Q1 2022 - 56

Investors
equities, 20% private equity, and 30% bonds,
with an extended duration, makes a bunch
of sense. Obviously, if investors can generate alpha
themselves, or through outside managers, and
make prudent use of leverage, they can enhance
their returns even more.
Pacholok: With interest rates at record lows, how
do you think the role of fixed income has changed, and
how do you think it'll continue to evolve?
Green: The role of fixed income is twofold:
to provide return and to provide ballast to equities.
I expect fixed income to provide both going
forward, but to a less degree than the past decade,
so you should lower your expectations
for bonds.
Browne: Traditionally, fixed income has
played three roles in portfolios. As Phil said, it
provides a stable source of income and
diversification to equities. And then there's
capital preservation.
The last two years have shown us that fixed
income can still provide a pretty attractive risk and
return profile, particularly during risk-off
periods. Fixed income also provides a reasonable
amount of equity diversification. In nine of
the last 10 recessions, excess bond returns have
been positive. There still is some room to run in
particularly significant risk-off periods, and
February and March of 2020 put that into focus. As
a starting condition today, if we were to go
into an extreme risk-off event where rates fell to
zero, the 10-year Treasury index would return about
13%. As for capital preservation, I think that
monetary policy over the secular horizon is going
to be muted, so fixed income will still provide
capital preservation.
Putting this all together, fixed income still plays
an important role, albeit a maybe less significant
role than in the past. Diversification is going
to play an increasingly important role. You have
to deploy active management and look at
alternative assets that complement traditional
fixed income-such as securitized mortgages or
securitized ABS [asset-backed securities]
products, private infrastructure or private debt,
private real estate, REITs, and high-yield and
emerging-markets credit.
56
Morningstar Q1 2022
Get ready for higher inflation for longer.
Phil Green
Lee: I think of fixed income a little bit differently.
The S&P 500 and emerging-markets equities may
look a lot different, but they still tend to be
highly correlated. The differentiation among fixed
income is huge, though. The difference between
short-duration U.S. TIPS [Treasury InflationProtected
Securities] and emerging-markets credit
is so wide, you can drive a truck through it.
I bucket fixed-income instruments by what they
can achieve in the total portfolio construct.
I have a core bucket that, to use an earlier term, is
the ballast of the portfolio. That's a low-volatility
asset that complements equity. Another
bucket is more defensive in nature-long-duration
Treasuries, for example, which performed very
well in the COVID sell-off. At current rates, they're
not going to provide as much defense as they did
before COVID, when rates were higher. But they're
probably going to provide a lot more defense
than they did in the first half of 2020, when rates
were much lower. The third bucket is returnseeking
fixed income: below-investment-grade and
emerging-markets debt.
You can use these buckets differently in portfolio
construction. Younger investors have very
high allocations to stocks, so use more of those
defensive fixed-income assets to diversify a
growth-oriented equity profile. In a portfolio that
is less equity-heavy, long-duration Treasuries
don't provide the same diversification benefit.
Credit, though, does provide diversification against
that core.
Morningstar - Q1 2022

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