As fixed income markets navigate a complex landscape characterized by elevated yields, shifting valuations, and evolving investment structures, investors face important questions regarding the role and performance of core and core plus bond strategies. Higher starting yields provide a meaningful income cushion, while supportive market fundamentals underpin valuations; however, emerging risks and increasing performance dispersion across managers demand careful consideration.
Key takeaways
Core and core plus strategies remain attractive, supported by strong fundamentals, ample liquidity potential, and elevated projected yields.
Active manager selection appears critical as emerging risks can potentially create significant performance dispersion.
Core bonds may provide valuable diversification and risk mitigation, while core plus strategies may offer enhanced returns for investors accepting higher risk and manager-dependent outcomes.
Core and core plus bond strategies in today’s market
We believe that core and core plus bond strategies remain relatively secure in today’s market, supported by three key factors:
1. Fundamentals remain strong. US corporate balance sheets have been managed conservatively in the post-COVID environment, with companies prioritizing financial stability. notably, the concentration of BBB-rated bonds in credit indices has been declining, reducing the proportion of lower-quality credits in typical portfolios.
2. Market technicals are supportive. Credit spreads appear to have benefited from strong technical conditions, supported by consistent demand, particularly from yield-based buyers. As yields have climbed, many institutional investors have actively bought into credit products to capture the all-in yield potential, providing underlying support for valuations.
3. Liquidity remains ample. Core and core plus strategies may offer significant liquidity, which is particularly important given the elevated volatility environment. This liquidity cushion helps managers meet redemptions and provides flexibility to capitalize on market opportunities without being forced sellers.
On top of this, starting yields are structurally higher today relative to what we have seen in the post-global-financial-crisis era, offering a better income cushion and a potential return profile that is expected to be more carry than price driven. As a result, carry may help offset price losses and dampen volatility, stabilize total returns, and shorten drawdown recovery times.
Carry and credit spreads support returns
We believe core plus strategies remain attractive despite greater downside risk, thanks to their ability to exploit credit sector opportunities and better withstand rate volatility. We continue to project above 10% total return potential for core plus strategies underpinned by three primary drivers. First, carry, which we expect to be the main driver of total returns over the next 12 months. Second, we expect modest tightening in credit spreads as fundamentals remain resilient and demand for yield continues. Third, we see potential for spread compression, particularly in higher-beta segments of the credit market such as subordinated bonds and corporate hybrids. We also anticipate the potential for rates to rally, which could drive returns in the duration-sensitive portion of core plus portfolios.
In short, elevated yield levels continue to provide meaningful income contributions, enhancing the overall return profile.
Navigating emerging bond market risks
At this time, we see two key risks emerging for core and core plus bond strategies. The first is stretched bond valuations, with credit spreads near historical lows; the second is the prevalence of bond ETFs (equitification of fixed income) has fundamentally altered the investment landscape, challenging the traditional business models of many core and core plus managers.
Performance outcomes across different investment strategies vary by manager approach. Larger asset managers typically rely primarily on asset allocation decisions (sector and rating tilts), or “beta” levers to generate returns relative to benchmarks. While useful, this represents a lower-quality source of alpha and limits differentiation. In contrast, active managers that combine asset allocation with bottom-up conviction trades tend to outperform in both alpha generation and risk mitigation. These managers may benefit from tactical positioning in addition to their ability to identify dislocations within the credit market.
Structurally, core bond strategies are more vulnerable to interest rate risk, which is likely to be elevated in the coming years due to heavier Treasury supply (driven by larger deficits and higher interest costs and less offset by global demand dynamics for US government debt) as well as the potential for inflation to remain stickier or reaccelerate amid a fragile geopolitical environment.
Core bonds as a diversifier
Core bonds remain effective diversifiers, responding to different drivers than equities and typically outperforming during market downturns. When risk appetite deteriorates and equity markets decline, bonds tend to benefit from flight-to-quality flows and falling rates. This is valuable during periods of uncertainty. Elsewhere, core bonds exhibit relatively low correlation with other risk assets, making them an efficient diversifier within a multi-asset portfolio. The potential for steady income generated by fixed income portfolios may also provide a return cushion that helps stabilize overall portfolio performance during volatile periods.
Dispersion among core plus strategies
Broadly speaking, core plus bond strategies will tend to exhibit higher dispersion than core bond strategies given the range of approaches utilized within “plus” sector allocations and how those exposures are managed. Based on our analysis, the dispersion of strategy outcomes within the core plus bond universe is ~2x the dispersion of strategies across the core bond universe, suggesting greater importance on manager selection and that strategy’s ability to actively manage these “plus” allocations.
Closing
Core and core plus bond strategies remain relevant in today’s market, but outcomes are increasingly driven by strategy selection and manager expertise. Elevated yields, supportive fundamentals, and favorable technicals create a favorable backdrop; however, stretched valuations and structural market shifts present real risks. Active managers with the skill to identify credit dislocations and navigate interest rate volatility are likely better positioned to outperform, while reliance on traditional beta exposures may face headwinds.
For investors, the key takeaway is clear: core bonds continue to provide portfolio diversification and risk mitigation, while core plus strategies may enhance returns provided they are implemented by managers capable of capitalizing on market opportunities while effectively managing heightened risks.