Winning with Defense—The Key to Successful Bond Investing

Downside protection is always important to clients – especially within fixed income investing as many clients rely on their bond holdings to provide ballast in times of market volatility. In this analysis, we explore how top performing multisector bond funds are able to generate consistent returns over time through a focus on effectively managing downside risk rather than maximizing gains. The results illustrate the power of defense – and downside protection – in achieving successful outcomes for clients.

Clients Dislike Losses and They Hamper Portfolio Success

All clients strongly dislike losing money in their investments more than they enjoy market gains. This tendency is supported by research in behavioral finance, such as Daniel Kahneman’s work on loss aversion. Additionally, when losses do occur, it takes even larger gains for a portfolio to recover. For example, a 10% loss requires an 11% gain to break even. This “cruel math” shows why managing downside risk is vital for long-term success. Protecting the downside allows gains to compound over multiple market cycles instead of losing ground.

Gain Needed to Break Even from an Investment Loss

Should Clients Focus on Downside Protection or Upside Opportunity Now?

Fixed income investors face a dilemma. The Federal Reserve seems to have completed its rate-hiking cycle, resulting in the highest yields in over 15 years. Persistent above-trend inflation has led the Fed to maintain a ‘higher for longer’ rate posture, keeping yields attractive. However, fixed income sector spreads are at their tightest levels in the same period, reflecting optimism about the U.S. economy and reduced recession fears. With yields elevated and spreads tight, should investors take risk or be defensive in today’s bond market? Is offense or defense the key to successful outcomes in fixed income? We did some in-depth analysis on Morningstar’s Multisector Bond category to find the answer. Over multiple annualized periods, we observe that top-performing funds achieve higher returns with lower standard deviation and down capture ratios than most peers. Notably, the down capture ratio has a stronger positive relationship with top returns. There’s an old adage that goes, “the best defense is a good offense,” but our findings suggest the opposite: the key to successful outcomes is managing defense effectively.

A Multisector Bond Case Study: Winning by Not Losing

We chose the Multisector Bond category as it includes funds with more flexibility than core bond or single-sector portfolios to invest across sectors, credit quality, and geography. This flexibility allows for differentiated outcomes based on portfolio positioning and risk posture. We examined what top-performing funds have in common in terms of how much risk they take in pursuit of these successful outcomes. We sorted every fund (Institutional share class) in the category by its standard deviation and down capture ratio over 3-, 5-, and 10-year periods. The key question: do top-performing managers achieve their results with more risk, or less?

Top Performing Managers Generally Have a Low Standard Deviation

Our findings show a consistently positive relationship between top performance and both lower standard deviation and down capture. For example, over a 3-year period ending 3/31/2024, 61% of managers with top-quartile returns also had the top-quartile (lowest) standard deviation. In contrast, only 13% of funds with top-quartile returns also had the lowest-quartile (highest) standard deviation. We also examined the down capture ratio, a measure of a fund’s relative performance in down markets, with lower figures being more desirable. Over 3-, 5-, and 10-year periods, top-performing funds showed an even stronger positive relationship with lower down capture. A full 70% (16 out of 23) of funds with top quartile (lowest) down capture over the past 3-years ending 3/31/24 achieved top quartile returns.

Even More Top Performing Managers Have a Low Down Capture Ratio

We found that down capture correlates more strongly with top performance than standard deviation. The 5-year annualized outperformance of top quartile (lowest) down capture managers versus the category median was 1.06% compared to 0.85% for top quartile (lowest) standard deviation managers. This trend holds over 3- and 10-year periods as well. The chart also shows how important it is for funds to achieve attractive defensive risk characteristics – on average, managers with a standard deviation or downside protection outside the top quartile typically perform in line or lag the category average on a 5-year basis (as shown) as well as on the 3- and 10-year time frames.

In a Head-to-Head Risk Comparison – Downside Capture Is the Better Metric

Over/Underperformance (%) versus the Multisector Bond Category Median for the 5-Year Period

Source: Thornburg and Morningstar Direct as of 31 March 2024.

Conclusion: The Best Offense Is a Good Defense

Managers with lower standard deviation and down capture ratios have historically produced top-quartile performance over multiple annualized periods. Down capture shows an even stronger positive signal than standard deviation, though both are relevant. Is this unique to fixed income? While expanding the analysis to other asset classes is beyond this article’s scope, we know fixed income is inherently asymmetric. The best investors can do is have principal and interest returned; the worst is a bond price falling to zero. Therefore, downside protection is essential. Should bond investing always be defensive? Not at all. At Thornburg, we believe fixed income portfolios should be defensively positioned for most of the market cycle. However, when markets sell-off or dislocate, active managers should work to quickly and efficiently deploy risk to take advantage of pricing opportunities. As markets normalize, a return to a more defensive posture, taking enough risk to capture upside without causing undue drawdown when the next sell-off occurs is prudent. Our analysis indicates that this approach to bond investing creates successful and more consistent outcomes for investors over time.