A New Look at Alpha in Your Fixed Income Portfolio
Person looking over a mountain vista

The Federal Reserve has provided a moderating voice to markets by stating they have no intention of increasing interest rates until at least 2023, but market participants have decided not to wait for them to actpushing 10-year yields higher by about 75 basis points since the beginning of the year. With decades of declining interest rates, fixed-income investments were the beneficiary of a significant performance tailwind. But with interest rates in some cases close to zero, it’s reasonable to ask the question: 

“With rates at historic lows, signs of inflation beginning to percolate, and an asymmetric risk profile to interest rates, where does one find positive return in a risk-prone fixed income portfolio?”

To answer this question, one needs to understand where “alpha,” or excess return to the benchmark, is derived in fixed income. When you deconstruct fixed income portfolios, whether they are multi or single sector strategies, there are two ways portfolio managers attempt to achieve positive returns. First, fixed income performance can come from  sensitivity to interest rates or duration management. Second, the amount of incremental yield investors receives for credit risk, country risk, or other event risks, broadly described as “spread” risk, can be an additional source of return.  

Given the current macroeconomic outlook and its potential for low risk-adjusted rates of return (or negative returns like those experienced by fixed income investors in the first quarter of 2021), perhaps a less traditional approach to fixed income portfolio management is required. At Build, we are challenging the conventional wisdom that specific risk buckets in fixed income are appropriate for investors who want a less volatile return path. Build offers an alternative alpha source that provides returns typically associated with fixed income sectors like high yield or emerging markets but with a less volatile return trajectory. And it comes from an unlikely source:  long-only call options on large-cap equities. Long equity call options have a unique return profile that have a known, limited downside and provides upside participation in stocks. Given potential growth prospects, options may offer a much better upside return profile. 

To measure the alpha in fixed income, one can use exchange-traded funds as a proxy for investment-grade credit, high yield, emerging markets (expressed in U.S. dollar terms), mortgage-backed securities, and senior loan strategies. We can then compare the returns of those funds to Build Asset Management’s Conservative Indexed Risk Control strategy and the respective sources of alpha. Build’s strategy owns a core group of high-quality (A+), fixed income bonds of U.S. treasuries, investment-grade credit, and asset-backed securities. In addition to the fixed income core, the firm employs the long-call options overlay to supplement returns as equity markets move higherBuild also offers Moderate and Aggressive strategies that provide relatively higher levels of equity exposure, commensurate with an investor’s risk profile. When we compare these fixed income sectors to Build’s Conservative Index Risk Control performance, the results are striking. 

Looking back over the last ten years, Build’s Conservative Indexed Risk Control strategy delivers a comparable, or better, annualized return when compared to the various fixed income allocations in our example in the table above. More importantly, it does so with a low Standard Deviation, a higher Sharpe Ratio, high level of Excess Return, Information Ratio, and with a moderate level of Tracking Error. Conservative Indexed Risk Control also delivers excellent Alpha, Beta and R-Squared numbers. What drives this outperformance? It’s Build’s adherence to a truly conservative approach to its fixed income allocation.  As mentioned, there are only two levers to pull in fixed income, duration, and spread. And the corollary to that is fixed income outcomes are digital: an investor will either receive its principal in full at maturity (with some income stream in the form of coupons) or get nothing. This 0 or 1 outcome requires a cautious approach to the foundational fixed income portfolio and where alpha comes from. Investment decisions are driven by the desire to protect to the downside and return investment capital. Build’s portfolio philosophy begins and ends with the defense of the portfolio. 

What helps to make Build’s strategy unique is that a significant alpha generator for the Conservative Indexed Risk Control portfolio comes from the long-only, equity call option overlay.  While it is not a fixed income asset, this supplement has the added benefit of creating additional portfolio diversification.  Looking at the correlation of various fixed income sectors compared to a traditional fixed income benchmark like the Bloomberg Barclays U.S. Aggregate Index (table below), Conservative Indexed Risk Control has a very low (.29) correlation. A review of the strategy’s contribution to return underscores this point.  The strategy’s back-tested data shows an average annual return of 6.45%, with fixed income providing 3.61% of that average return and equity options delivering 2.84%fairly balanced profile. Last year’s since-inception performance solidified this profile, with a total strategy return of 8.54%, comprised of 6.32% from the options overlay and 2.85% coming from fixed incomeand –63 basis points from cash*.  

Build believes that this new approach to a fixed-income portfolio construction is designed specifically for our time. Conservative investors are experiencing the punishing consequences of the fiscal and monetary decisions made worldwide after the 2008 financial crisis.  In this new regime, investors are forced to seek risk assets for higher returns as interest rates have been intentionally muted by the Fed and easy money policies. Given that the rules have changed, conservative investors must adapt and rethink their approach to conservative investing.    Using Build’s approach, investors can be rewarded for equity appreciation without the direct exposure, thereby mitigating sequence of return risk without sacrificing long-term growth. 


* The hypothetical back-tested period ranges from December 19, 1991 through January 27th, 2020, and have been independently verified by a third-party auditor. Actual strategy performance begins on January 28th, 2020.

Related Articles

The Giving Tree Has Little Left To Offer

The Giving Tree Has Little Left To Offer

Decades of economic policy have whittled bonds down to just a stump, offering no fruit or shade to investors. It’s time to shift your bond strategy as we approach the twilight of the 40-year fixed income bull market.

“Money Life with Chuck Jaffe” Ft. John Ruth

“Money Life with Chuck Jaffe” Ft. John Ruth

"Flip it upside down and start over." - John Ruth, Build Co-founder and CEO If the 60/40 Portfolio Doesn't Work, Turn it on its Head. Our CEO explains how Build is completely rethinking the 60/40 portfolio on this weeks 'Money Life with Chuck Jaffe.' Listen to the...

Contact Us

Build Asset Management, LLC (a/k/a Build Asset Management and/or GetBuilding.com) is an investment adviser registered with the U.S. Securities and Exchange Commission.  Registration of an investment adviser does not imply any skill or training.  Build Asset Management does not provide legal or tax advice.  Please consult your legal or tax professionals for specific advice.

Build does not guarantee any minimum level of investment performance or the success of any index portfolio, index, mutual fund or investment strategy. Past performance does not guarantee future results. There is a potential for loss in any investment, including loss of principal invested. All investments involve risk, and different types of investments involve varying degrees of risk. Investment recommendations will not always be profitable.

No representation is being made that any client account will or is likely to achieve profit or losses similar to those shown in hypothetical back-tested performance. Impacts of federal and state taxes and trading costs are not included in the results of index portfolio or index returns. Hypothetical back-tested performance information shown in text, charts, tables and graphs is provided for informational purposes only and should not be considered investment advice or a recommendation to buy or sell any types of securities. Unlike  actual performance, hypothetical, back-tested or simulated results are achieved by means of the retroactive application of a back-tested model itself designed with the benefit of hindsight. The back-testing of performance differs from actual performance because the allocation rules may be adjusted at any time, for any reason, and can continue to be changed until desired or better performance results are achieved. Back-testing does not reflect actual trading in any account.

Strategy composition information such as strategy allocation, sector weight, and top five holdings is provided as of a specific date and is subject to change.  The top five holdings are representative of the model portfolio and actual account holdings may vary due to inflows, outflows, liquidity needs or other requirements of the account. It should not be assumed that an investment in the securities identified in the top 5 holdings was or will be profitable.  The holdings identified do not represent all of the securities purchased, sold, or "recommended for our clients." To obtain the contribution calculation methodology and a complete list of every holding’s contribution to the overall portfolio’s performance during the period, please contact info@getbuilding.com.

For more information contact us at (833) 852-8453.  General Disclaimers.

Privacy Policy