Today’s fixed income investment environment can be especially negative for bond portfolios heavily weighted with core holdings such as Treasuries, agencies, MBS, and investment-grade corporate bonds—all of which are highly sensitive to rising interest rates and changing fiscal and monetary policy.

A core plus strategy provides investors broad fixed income sector exposure and the flexibility to pursue returns from sectors or markets that may be less affected by rising U.S. interest rates, including those outside of the U.S.

Beyond the core holdings mentioned above, a core plus strategy includes U.S. high yield bonds, U.S. dollar denominated emerging market debt, and other investment-grade non-U.S. dollar denominated debt.

Over the last 34 years, long-term bond investors have enjoyed the greatest bull market for bonds in history. In 1983, the yield on the benchmark 10-year U.S. Treasury Note was over 10 percent; as of November 30, 2017, the yield was 2.42 percent.

Today’s reality is that the economic recovery is gaining strength and interest rates are trending upward, albeit incrementally. Many bond investors have never experienced an extended period of rising rates and the adverse effect it can have on their portfolios.

While core bond holdings in today’s economic environment can still play a key role in volatile markets, they can also be a severe drag on risk-adjusted returns.

Core Plus Diversification to Boost Returns

It is often said that a proper diversification approach offers the only “free lunch” in investing. Diversifying a bond portfolio beyond core holdings offers the opportunity to mitigate the effects of rising interest rates while achieving higher risk-adjusted returns.

The key to core plus holdings is their relatively low correlation to U.S. Treasuries and MBS, and their potential ability to generate higher income and capital appreciation. See the chart below for the annual returns of core and core plus indices.