After more than three decades of declining long-term interest rates and six years of near-zero rates on the short end of the curve, the bond markets in the United States have clearly reached an inflection point.

Few economists are predicting significantly higher interest rates anytime soon given the scarcity of yield in the global fixed-income markets and the high demand from investors, both institutional and retail.

But the challenge for fixed-income investors is still a pressing one: How does one construct a portfolio that can not only withstand the effects of rising rates, but can also deliver attractive total returns in such an environment?

At John Hancock Investments, where I’m an executive, we believe that a passive approach that relies on declining interest rates as the primary driver of returns isn’t likely to deliver the kind of performance that investors have grown accustomed to.

Consider this: Over the past 30 years, the duration, or interest-rate sensitivity, of the Barclays U.S. Aggregate Bond Index has been steadily creeping higher, while its yield has steadily fallen.

What makes this a dangerous combination is the fact that the major risk, by far, in the index is—you guessed it—interest rate changes.

Investors in a strategy based on Barclay’s index today, with similar duration and yield characteristics, would suffer losses in excess of 3% over a 12-month time horizon given a 100 basis point increase in interest rates.

Those kinds of losses are a significant issue for an allocation that often represents the most conservative portion of investors’ portfolios.

And if a 100 basis point jump in yields seems unlikely, consider that for much of 2015, the yield on the 10-year U.S. Treasury was below 2%; a year earlier, it had been close to 3%. None of this is to suggest that the solution for investors is to aggressively manage their portfolios’ durations. Given how difficult it is to forecast the timing and magnitude of interest-rate changes, we believe that betting heavily on rates rising is just as risky as taking the opposite stance.

The more prudent strategy is for investors to take measures to ensure their portfolios are exposed to a wider variety of risks and, therefore, to a broader range of opportunities.

One of the benefits of the manager-of-managers approach we take is that we’re able to bring together specialized investment teams with unique and differentiated styles and processes—a key feature in constructing a more broad-based portfolio for today’s bond market in transition.

The easiest way to expand the drivers of returns in a bond portfolio is simply to hold a broader range of bonds. More than a third of the Barclays index is U.S. Treasury debt.

When you consider that Fannie Mae and Freddie Mac remain in conservatorship, more than 75% of the index has some form of government backing. 

Investing in areas beyond the bellwether index is not taking on more risk; rather, we would argue it represents a diversification of risks, and therefore offers the potential for reducing overall volatility.

For example, consider that nearly two-thirds of emerging-market debt is rated investment grade, and that the issuing countries in many cases have stronger balance sheets and demographic trends to support them than their developed-market counterparts.

Or consider that in an environment of rising rates (which usually corresponds with an improving economy), the fundamentals in the high-yield market are typically improving, which can actually be good for prices. For outright protection from the effects of rising rates, consider that floating-rate notes, whose coupons periodically reset to reflect changes in short-term interest rates, posted solid gains in 2004, 2005, and 2006—the last cycle of U.S. Federal Reserve rate tightening.

These market segments are often skipped over in traditional strategies; to invest in them effectively requires managers with the skill sets and experience to navigate the unique risks each represents.

Half the battle in bond investing is finding attractive sources of income, and one of the best ways to do that today is to take a more global perspective. 

The size of the fixed-income investment universe triples by shifting from a U.S.-based investment set to a global one, and doing so need not entail significantly higher levels of risk or volatility. Australia, New Zealand, and South Korea—three highly rated developed markets—all offered higher yields than the United States on their 10-year government debt as of the end of March. 

The same was true among certain investment-grade emerging-market countries, including Mexico, Thailand, and the Philippines. 

In an environment where many market watchers are anticipating coupon-like returns in the fixed-income markets, pursuing high-quality and higher-yielding opportunities could make a significant impact on performance. 

Currencies can also play a significant role in driving returns, as well as increasing diversification. An unhedged investment in the Barclays Global Aggregate Bond Index, for example, had a significantly lower correlation to the U.S. aggregate index than the hedged version.

But a passive approach here has its risks, too; exposure to foreign currencies increased the index’s volatility. The key takeaway for investors is that adding global securities and global currencies to a portfolio results in a much broader opportunity set—for active managers with the capacity to sift through those opportunities, the potential benefits can be significant.

Ultimately, there are no shortcuts to generating attractive returns in today’s bond markets.

But we believe that opportunities do still exist, especially outside the narrow confines of a passive, U.S.-centric approach.

The keys for navigating today’s market in transition will be to pursue a more flexible strategy while taking a global view of the bond markets—two principles that underpin our strategy at John Hancock Investments.

Andrew G. Arnott is president and CEO of John Hancock Investments

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