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.
Annual Returns of Core and Core Fixed Income Indices

Sources: Bloomberg, JP Morgan (*As of 10/31/17)
To better understand the contribution of core plus holdings to risk-adjusted returns, it’s worth a look at the unique characteristics that make them attractive in that role.
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High Yield Bonds. As an asset class, high yield bonds offer attractive value given the higher total return potential over other fixed income sectors. Many well-known companies issue high yield bonds. They typically have a credit rating of BB or lower by Standard & Poor's, or Ba or below by Moody's Investors Service due to potential higher default risk in relation to investment-grade bonds. Among the most attractive characteristics of high yield bonds, however, is their low historic correlation to investment-grade bonds, and their lower sensitivity to rising interest rates. High yield bonds are negatively correlated with Treasuries and can generate positive returns despite rising rates. Adding high yield bonds to a Treasury portfolio can actually decrease risk and improve returns. That makes high yield bonds a powerful diversifier in a core bond portfolio. For the past 30 years, the correlation of high yield bonds to 10-year U.S. Treasury Notes has averaged only 0.14, according to Market Realist.
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U.S. Dollar Denominated Emerging Market Debt. Emerging market bonds have proven to be another powerful diversification tool due to their relatively moderate correlation to core fixed income asset classes. These are bonds issued by some of the more interesting developing countries of the world such as Mexico, Brazil, and India. Emerging market bonds are more volatile than U.S. high yield bonds, but they have a lower correlation to U.S. equities, which is an indication of their diversification potential in a core portfolio.
As an asset class, emerging market corporate bonds are particularly attractive due to the economic growth achieved in the last couple of decades, especially when compared to the growth of developed markets. Current fundamentals and global monetary policies continue to favor emerging markets, which are expected to grow for some time to come. They bring attractive yields to a portfolio, while the asset class continues to grow in size and diversity, providing the opportunity to achieve broad exposures to emerging market, sovereign, and corporate issues.
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Non-U.S. Dollar Denominated Debt. When considering international debt as a core plus holding, whether it’s from emerging markets or developed countries, we want to focus on issues denominated in a currency other than the U.S. dollar. U.S. dollar-denominated bonds have a high correlation to U.S. dollar asset classes, which is why we like to diversify our currency holdings for U.S. investors.
While non-dollar positions can introduce more currency risk to a portfolio, they offer the opportunity to access yields that exceed those found in the U.S. markets and they lessen exposure to U.S. interest rate fluctuations.
What We Believe
We believe that a sound core plus fixed income strategy enables portfolio managers to source a broader set of asset classes to achieve higher risk-adjusted returns. These core plus holdings can simultaneously serve as a counterweight to more interest rate-sensitive assets.
As with any active portfolio strategy, the challenge lies in identifying the specific opportunities within each unique market environment. At LM Capital, we conduct a thorough top-down assessment of the global macroeconomic environment and key capital market drivers. We then combine this analysis with bottom-up, security-specific research to determine the best way to deploy capital at any given time.
With volatility still fairly low, we believe now is the opportunity to make prudent portfolio adjustments in a measured way to counter further interest rate risk and to potentially boost risk-adjusted returns through core plus holdings.
LM Capital specializes in active fixed income management using a top-down, macroeconomic approach, supported by in-depth, bottom-up research, in an effort to provide attractive risk-adjusted returns.
Statements by LM Capital are on its expectations, estimates, projections, and opinions and involve known and unknown risks, uncertainties, and other factors or are otherwise forward-looking statements. Actual events or results may differ materially from those reflected or contemplated in such statements. In addition, certain statements contained herein are from, or based on data from, sources or data presumed by LM Capital to be reliable, including Bloomberg, and LM Capital makes no representation or warranty, express or implied, with respect to their accuracy, timeliness, or completeness. Accordingly, LM Capital expressly disclaims any responsibility or liability for any loss or damage that may be incurred by any party who relies on the written materials contained herein. Investing in securities, including fixed income securities, involves risks. You may lose some, a significant portion of, or all of your investment.
This information is provided for discussion purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any securities. It also does not constitute a solicitation for LM Capital’s investment advisory services. LM Capital is registered with the SEC as an investment adviser. SEC registration does not imply any certain level of skill or training.
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