Is your bond ready to adapt?

Dramatic changes in the global economy and markets since the financial crisis have reshaped the investment landscape. Risks and opportunities are surfacing in unexpected places and we believe that addressing these changes effectively requires fixed income investment strategies that are more flexible and opportunistic.

Investors looking for income and stability have historically focused on government bonds, while those looking for higher return potential have focused on emerging market bonds, high yield corporate bonds and other riskier sectors of the market. In many ways, the fallout from the financial crisis has turned this paradigm on its head.

Major government bond markets today offer investors a yield of about 2.1 percent, one of the lowest yields ever on major government bonds (Barclays Global Aggregate Bond Index as of Aug. 1, 2011). Perhaps more importantly, low yields may also undermine the role of government bonds as a source of stability in an overall portfolio.

That’s because income is a key buffer against the risk of rising interest rates. For example, in four of the last 11 years, rising interest rates have caused the Barclays Global Aggregate Index (which generally consists of more than 50 percent government bonds) to decline in price, resulting in a capital loss. However, the index’s total return was positive in all 11 of those years because income more than offset the price decline.

At the same time, many major developed governments are running large deficits and are borrowing more and more to fund those deficits. These countries are now “walking a tightrope”, trying to preserve growth, which is needed to support existing debt, while tightening fiscal policy in an effort to reduce their borrowing needs.

Any missteps could lead investors to demand much higher rates for investing in government bonds and existing bonds that pay lower rates would lose value, as has already occurred in several European countries.

Considering today’s small income buffer and rising fundamental risk, we think the risk/return profile of developed government bond markets is materially different from its historical profile.

Fortunately, the global bond market is more than just developed government bonds. Other sectors of the market have also undergone significant — but more positive — changes following the financial crisis.

Some of these are long-term, such as the transformation of many “emerging” countries into key drivers of global growth. Many countries still considered “emerging” offer bond investors better growth and debt fundamentals compared to their developed-country peers, as well as higher income.

Other changes are more cyclical in nature, but create potential opportunities for investors willing to expand their search for value in the bond market.

In the wake of the financial crisis, the corporate sector has become much more conservative, cutting costs, reducing leverage and raising cash. These are material changes that reduce risk for bond investors, while corporate bonds continue to offer yields we consider attractive relative to government debt.

In our view, these changes in the bond market require an equally fundamental change in the way investors approach their bond portfolio. The traditional paradigm has been a constrained approach to fixed income, focusing primarily on government and government-related debt while making small allocations to other sectors that might provide more attractive return.

This approach made sense in world where government debt offered attractive income and low risk, and other sectors were more prone to volatility. We think it makes less sense today. Non-government sectors certainly still hold the potential for volatility. But so does the developed government bond market, as we’ve already seen in parts of Europe.

What’s the answer? First, we think bond portfolios need to be more global, pursuing opportunities wherever they arise. Second, we think risk should be taken based on the opportunity set and diversification, rather than consistently focusing on government debt when the reward may not be worth the risk.

Finally, in an interconnected world where risk appetite is a global force and can shift on a moment’s notice, we think bond portfolios should have the flexibility to make meaningful shifts between riskier sectors and government bonds depending on the environment.

In our view, this approach offers investors the best opportunity earn an attractive return for their bond market risk.

The writer is managing director of Goldman Sachs Asset Management. The opinions expressed are his own.