Short Is Still Sweet: SDOFI Takes the Cake in Today’s Fixed Income Regime

In a world where inflation is high and the monetary policy outlook is so uncertain, why extend out the curve and expose yourself to more duration risk for less yield, when you can simply adhere to the time-tested principle of keeping it short and sweet…

The pandemic has given rise to transformational changes, and the fixed income market has certainly not escaped its reach, and we now find ourselves in a much different regime than the one we grew accustomed to over the past decade. In the last two years the Fed increased rates at the fastest pace in 40 years, which has led to a challenging environment for fixed income returns.

However, our Short Duration Opportunistic Fixed Income (SDOFI) strategy is designed to preserve capital and produce positive returns across multitude of environments, where it has been in line with expectations since 2009. This includes 2021 and 2022 where the fixed income market landscape was difficult to navigate. The structure of our strategy enabled us to find a way to preserve capital for investors despite the sharp move higher in rates.

Figure 1: Positive total returns in challenging environments

Source: LGIM America and Bloomberg. ICE BofAML USD 3-Month Constant Maturity. Data as of December 31, 2023. Past performance is not indicative of future results. Inception date is January 31, 2007. Please note that the composite inception date is February 29, 2008. The "since inception" figure in the table above represents performance as of the last performance break noted in the following. The composite has a break in its performance track record for the month of March 2018 due to significant cashflows in underlying portfolios. Therefore, certain composite statistics are not available in accordance with GIPS Standards. Additional information is available upon request. Gross composite performance is presented before management fees, subscription charges by pooled funds, and extraordinary expenses but after trading costs, non-reclaimable foreign withholding taxes and pooled fund operating expenses. Net performance, which is further described in the attached GIPS Composite Report, is calculated by deducting the model fee from the gross composite return. The model fee is the maximum potential management fee charged to an account in the composite, although actual fees may vary. The model fee is 0.25% per annum since inception. Returns reflect the reinvestment of dividends and other income earnings. Investment advisory fees are described in Part 2A of Form ADV. All objectives and limits are for informational purposes, are forward looking statements that are inherently uncertain and are not guaranteed. Actual results may vary substantially.

The key ingredients

Our strategy is managed by an experienced team and benefits from an expanded toolkit, with the flexibility to invest in investment grade and high yield credit, securitized products and emerging markets - while always maintaining an investment grade rating overall. We also utilize credit derivatives like CDX and TRS to efficiently hedge credit risks when we expect a deterioration in the outlook. 

Finally, the rate duration of the strategy is maintained around the 0 bound, limiting exposures to rate moves.

The way it's best served 

1. SDOFI as a complement to Bloomberg US Aggregate Bond Index (US Agg)

Despite having a duration pinned around 0, SDOFI currently yields more than the US Agg – 6.1% vs. 4.9% - while carrying a historical average correlation of 0.09.¹

By allocating some of the existing fixed income pool to a strategy like SDOFI, investors can diversify away from some of the more dominant features of the US Agg:

• Limited scope: The US Agg only tracks bonds that are of investment grade quality or better. This means it excludes certain segments of the bond market, such as high-yield bonds and emerging market debt, which come with increased risks of default/downgrade and heightened volatility, respectively, but can drive strong risk-adjusted returns.
• Rate sensitivity: The index carries a duration of 6.1 years in a new, unpredictable interest rate environment.
• Historical bias: The US Agg was founded in the 1970s, and some of its data dates to only 1986, a time when interest rates began to decline from all-time highs. Should the higher-for-longer rate environment persist, the index could lose the natural support of falling rates through time.

2. SDOFI as a cash enhancement

The well-known mantra “cash is trash” is no longer appropriate given today’s market backdrop. With elevated short-term rates and an inverted yield curve investors can benefit from a dynamic solution that exploits opportunities across the fixed income landscape while adding a modicum of increased risk. 

Such a strategy can come with meaningful liquidity as well. Over 40% of SDOFI’s portfolio has a weighted average life of under 1-year and roughly 90% falls under 5-years.² This is evident in our experience through the Fall of 2022 where collateral calls intensified amidst rapidly rising rates. Our fund met 100% of same-day outflows, selling pro-rata across holdings. In this case, the portfolio saw only marginal increases in trading costs ultimately delivering 98-100% of fair value.

Amidst a sea of change the one principle that seemingly remains unscathed is “short is still sweet.”

1. Source: LGIM America and Bloomberg. Data as of March 31, 2024.
2. Holdings, allocations and weights are subject to change without notice and may not be representative of current or future allocations.

Disclosures

The material in this presentation regarding Legal & General Investment Management America, Inc. (“LGIMA”) is confidential, intended solely for the person to whom it has been delivered and may not be reproduced or distributed. The material provided is for informational purposes only as a one-on-one presentation, and is not intended as a solicitation to buy or sell any securities or other financial instruments or to provide any investment advice or service. LGIMA does not guarantee the timeliness, sequence, accuracy or completeness of information included.  The information contained in this presentation, including, without limitation, forward looking statements, portfolio construction and parameters, markets and instruments traded, and strategies employed, reflects LGIMA’s views as of the date hereof and may be changed in response to LGIMA’s perception of changing market conditions, or otherwise, without further notice to you. Accordingly, the information herein should not be relied on in making any investment decision, as an investment always carries with it the risk of loss and the vulnerability to changing economic, market or political conditions, including but not limited to changes in interest rates, issuer, credit and inflation risk, foreign exchange rates, securities prices, market indexes, operational or financial conditions of companies or other factors. Past performance should not be taken as an indication or guarantee of future performance and no representation, express or implied, is made regarding future performance or that LGIMA’s investment or risk management process will be successful. 
 
In certain strategies, LGIMA might utilize derivative securities which inherently include a higher risk than other investments strategies.  High yield bonds involve greater risks of default or downgrade and are more volatile than investment grade securities, due to the speculative nature of their investments. In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from social, economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Investors should consider these risks with the understanding that the strategy may not be successful and work in all market conditions.   

Reference to an index does not imply that an LGIMA portfolio will achieve returns, volatility or other results similar to the index. You cannot invest directly in an index, therefore, the composition of a benchmark index may not reflect the manner in which an LGIMA portfolio is constructed in relation to expected or achieved returns, investment holdings, portfolio guidelines, restrictions, sectors, correlations, concentrations, volatility, or tracking error targets, all of which are subject to change over time.  

No representation or warranty is made to the reasonableness of the assumptions made or that all assumptions used to construct the performance provided have been stated or fully considered.

All LGIMA performance returns in this presentation are presented gross of fees, but are accompanied with an explanation of performance net of investment management fees. 

The presentation may also include performance that is based on simulated or hypothetical performance results that have certain inherent limitations.  Unlike the results in an actual performance record, these results do not represent actual trading.  Because these trades have not actually been executed, these results may have under- or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity.  Simulated or hypothetical trading programs in general are also subject to the fact that they are designed with the benefit of hindsight.  No representation is being made that any account will or is likely to achieve profits or losses similar to these  being shown.

Information obtained from third party sources, although believed to be reliable, has not been independently verified by LGIMA and its accuracy or completeness cannot  be guaranteed. 

Unless otherwise stated, references herein to "LGIM", "we" and "us" are meant to capture the global conglomerate that includes Legal & General Investment Management Ltd. (a U.K. FCA authorized adviser), LGIM International Limited (a U.S. SEC registered investment adviser and U.K. FCA authorized adviser), Legal & General Investment Management America, Inc. (a U.S. SEC registered investment adviser) and Legal & General Investment Management Asia Limited (a Hong Kong SFC registered adviser). The LGIM Stewardship Team acts on behalf of all such locally authorized entities.

Certain portfolios in the strategy may not adhere to all transactions described in this commentary. Additional information about the strategy and its objectives is available upon request. Certain of the information contained herein represents or is based on forward-looking statements or information, including descriptions of anticipated market changes and expectations of future activity. Forward-looking statements and information are inherently uncertain and actual events or results may differ from those projected. Therefore, undue reliance should not be placed on such forward-looking statements and information. There is no guarantee that LGIM America's investment or risk management processes will be successful.

Certain of the information contained herein represents or is based on forward-looking statements or information, including descriptions of anticipated market changes and expectations of future activity. Forward-looking statements and information are inherently uncertain and actual events or results may differ from those projected. Therefore, undue reliance should not be placed on such forward-looking statements and information. There is no guarantee that LGIM America's investment or risk management processes will be successful.

LGIMA claims compliance with the Global Investment Performance Standards (GIPS®). Please contact LGIMA at 312.585.0300 to obtain a GIPS Composite Report for the strategy presented in this advertisement. GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein.