Many investors, whether individual or institutional, hold a diversified bond portfolio primarily to mitigate the volatility inherent in stocks or other risky assets. However, with yields presently at or near historic lows, more investors view the bond market as abnormally risky.
Indeed, the preponderance of thought is that if and when interest rates rise, the fixed income portion of an investor’s aggregate portfolio may face volatility and loss. Coincidentally, the phrase “bond bubble” is gaining currency.
Given many investors’ concerns, we offer some perspective on the prospective risk of higher interest rates to a broadly diversified bond portfolio.
The Importance of Asset Allocation – “Financial Analysts Journal”
Roger G. Ibbotson reviews the question: What is the impact of the long-term asset allocation policy mix relative to the impact of active performance from timing, security selection, and fees?
His conclusion: The time has come for folklore to be replaced with reality. Asset allocation is very important, but nowhere near 90 percent of the variation in returns is caused by the specific asset allocation mix.
Instead, most time-series variation comes from general market movement. Xiong, Ibbotson, Idzorek, and Chen (2010) showed that active management has about the same impact on performance as a fund’s specific asset allocation policy.
What Drives the Performance of Convertible-Bond Funds? – “Journal of Banking and Finance”
This paper examines the performance of U.S. mutual funds that invest primarily in convertible bonds.
Multi-variate cross-sectional analyses show a significant relation between a fund’s performance and its asset composition: The higher the difference in the percentage of assets invested in convertible bonds compared to the percentage invested in stocks, the higher the performance, on average.
The authors show that this result can be explained by factors associated with investment opportunities in the convertible-bond market and trading strategies related to convertible arbitrage, as typically performed by hedge funds.
Overall, convertible-bond fund performance measured by alpha is comparable to a passive investment in stocks, bonds, and convertible bonds. This performance is the result of weak selection skills and successful timing strategies related to convertible arbitrage.