Skip to main content

Core Fixed Income — Alive & Well

Mark Jackson, CFA


Henry Song, CFA

Five years ago, the “death of core” was a trending topic. Fast forward to today and we continue to believe, as we did then, that core remains a vital part of a well-balanced fixed income portfolio. Learn why.


The following text is a transcript of portions of the speakers’ podcast originally recorded in July 2021. This transcript solely represents the views of the individuals who spoke, which are subject to change.

Video 1: The Beauty of Simplicity — Taking the Guesswork Out of Fixed Income Investing

Douglas Gimple, Senior Portfolio Specialist:

Our strategies launched on July 5th, 2016, and it was on the heels of the original Brexit vote announcement. And at a time when the 10-year Treasury was yielding, what was at that point, a historic low of 1.37%. Little did we know what was to come in the future and that the 10-year yield would reach a new all-time low of 0.508% in early August of last year. We have never attempted to predict where rates are headed and opt to focus instead, as we've mentioned, on security and sector selection, rather than to put our client's money at risk predicting where rates may go. So Henry, I'll ask you, how has the past five years just served as a reinforcement of that aspect of the philosophy?

Henry Song, CFA, Portfolio Manager:

I think the last five years is a great reminder that you have to be extremely, extremely smart to be able to predict rates and the movement and the way it moves and the pace it moves. To us, it seems like an impossible exercise. Rather than spending so much time trying to predict future rate movement, to Mark's point, we're looking for cash flows that make a lot of sense. There are a lot of data points out there people can point to, especially in today's environment, everyone's talking about big data, there's all sorts of new data providers there. To Mark's point, there are better and more efficient ways to analyze prepayments, cash flows, but there's also just way too much data overload. So, I think what we are trying to do is, almost call it beauty of simplicity. There are things we know that works, and we're just going to stick to that.

We're not going to use the latest technology necessarily but seeing how things perform and stick to what we think has always worked, rather than a focus on hundred data points, focus on the five that really matter. That has proven that it really works in the different environment in the last five years we have seen. Again, this philosophy goes back 30 plus years. I think as long as we can continue to identify the key elements that dictate a cashflow and what makes it cheap, I think that's going to be, essentially our secret sauce, right?

Douglas Gimple, Senior Portfolio Specialist:

The beauty of simplicity—I really like that one. I’m going to use that on my own many times.

Video 2: Core Fixed Income — Alive & Well

Douglas Gimple, Senior Portfolio Specialist:

The Diamond Hill Core Bond Strategy has experienced consistent growth since its launch in 2016. And as we've reached our five-year anniversary, we're starting to see an increase in interest. So, Henry, I'll ask you, is it safe to say that core is not dead, and in fact remains a vital part of a well-balanced portfolio?

Henry Song, CFA, Portfolio Manager:

I think that question is almost similar to, "Where are rates going to go into the next three months?" It's very similar to that. And it's really hard for me to say for sure, but looking at all the data, we started talking about the death of core really post 2008. All these unconstrained bond funds came about and you started hearing some of the consultants and others are doing their own calling it “satellite core” approach where they're picking managers from various sectors to combine, to make a core work.

But the results so far, we're over 10 years in this experiment now, but the results is very much a mixed bag. People were expecting these go anywhere funds, or mix and match approach, to far outperform the Agg index. And that really just hasn't been the case. And they actually probably added a lot more volatility to their portfolio as a result.

In theory, that should really work if you're picking the right managers, doing the right thing. In various sectors, if you pick the best manager in every single sector, in theory, you should do better. But I think the issue ends up being one, sometimes it's hard to pick a manager; and two, you're going to have an overall allocator who's allocating amongst these different sectors, making a macro call. And that's extremely difficult, that's basically our belief. It's very difficult to make that sort of call. So, in some ways, again, beauty of simplicity, I think sticking to something that's simple, I think it works.

And I think the other part of it too, why those funds haven't done as well. And I really think part of that is just also the fees, right? These newer, exciting strategies had much higher fee associated with them, or when you start mix and match different managers in different sectors, those sector funds tend to charge a higher fee as well. So, at the end of the day, your hurdle of beating the Agg index became higher. And so, that also didn't help in their cause as well.

Video 3: The Evolution of the Securitized Market

Douglas Gimple, Senior Portfolio Specialist:

So Henry, I'll gear this question towards you, our strategies from short to intermediate to core tend to focus on securitized as a way of delivering excess return to clients. Short duration in particular is fairly unique and it's universe with such a heavy focus on the securitized market. What was the thought process around launching and designing this product and how has it fared since its launch in 2016?

Henry Song, CFA, Portfolio Manager:

Yeah, the securitized market's always been interesting. Historically, we had an overweight in the securitized space. Mark talked about earlier, the creation of a CMO market in the early eighties. There were just a lot of inefficiencies in that space. I think if you just look at a sheer number of CUSIP's available in the space just makes it very, well because when you think about mortgage, you can essentially indefinitely slice and dice into different cash flows, different tranches. So that makes it interesting and also makes it hard for new technology to come into the space to disrupt it. I've talked about electronic trading in the corporate space, that doesn't really exist in the mortgage space.

As the market continued to evolve, especially in post 2008, we've seeing some newer asset classes coming to the market. I think some of the catalysts were, for example, GE was broken up, GE Capital. They did a lot of this stuff on the balance sheets before and now they come to the asset backed securities market, financing various securities. So we found a lot of attractive new asset classes coming to the market that weren't exactly accepted by most of the investors initially. And we continue to see more of that happening now.

So, for example, in the green revolution, we're talking about now, we started seeing solar panels, Tesla start securitizing their deals, which is all just very different than what has been in the market historically. So all of that just creates a lot of opportunities. And to us, when we look back, it just never made sense why something that has so much more enhancement gets worse rating oftentimes than their corporate counterparts and trading on much wider spreads. We really contribute that to something that's in early stage of development, not massively popular and not being part of the index really also hurts it as well.

But on the flip side, there are less disruption or if you call, sometimes you can think about it as a manipulation because when the index people started buying it, then the value really erodes away very quickly.

So, it's done well, the short duration strategy you mentioned has a pretty unique proposition where it's 80% plus in securitized products, we have held a pretty steady yield advantage over the benchmark over the last five years, roughly around 200 basis points in that five-year time span. And so, I think that has proven that it works really well in this space. Certainly, like we talked about last March, had its fair of challenges when liquidity dried up in the space, but outside of that one episode has held up extremely well. And I think that provided a lot of value for people who have a longer time investment horizon and who can stomach a little bit of volatility.

Video 4: Managing Change with a Consistent Approach

Douglas Gimple, Senior Portfolio Specialist:

Even as markets evolve and change, the one constant in our philosophy and process has been the commitment to a focus on bottom-up security selection in an effort to deliver consistent returns. So Mark, I'd like to get your thoughts as to why you believe this philosophy and process has been able to endure through a variety of market cycles with so little change.

Mark Jackson, CFA, Portfolio Manager:

I think the answer to that is, the one fundamental element of the process is we're constantly searching for bonds that provide cheap, risk adjusted cash flows. And do you think about this process when it was developed back in the mid-eighties, markets were evolving, interest rates were very high. The mortgage-backed securities market was in its relative infancy, but it was growing very rapidly, and it was developing very rapidly in the sense that, instead of just pass-through mortgages, the CMO market was rapidly developing and the tools to be able to analyze cash flows and pre-payments, and the optionality of mortgage-backed securities, the ability to analyze those cash flows was improving rapidly.

When you look at the fixed income markets in there, they're just not efficient. There's a lot of inefficiencies that you can take advantage of. And I think that search for cheap risk adjusted cash flows and barring them in a way that when you do get something wrong, it's not going to ruin your performance. It will have a small negative impact, but if we can get seven out of 10 decisions right, we're going to have some good success from a performance standpoint. And I think that's true in really any market environment, if we're buying bonds that are relatively cheap, relative to what's available, over time, we can realize that cheapness as securities revert back to fair value.

The views expressed are those of the portfolio manager as of July 2021, are subject to change, and may differ from the views of other portfolio managers, research analysts or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Investing involves risk, including the possible loss of principal. Past performance is not a guarantee of future results.

The Bloomberg Barclays U.S. Aggregate Index is an unmanaged index representing the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through, and asset-backed securities.

As of June 30, 2021, Diamond Hill owned debt in Tesla Auto Lease Trust.

Click here for Short Duration Securitized Bond strategy performance.

Subscribe to Insights

Latest Insights

Blog | 09.09.2021

Tapering vs. Tantrums — What's In Store?

by: Douglas Gimple

As more tapering rhetoric comes out, are there lessons to be learned from previous tapering and tantrums? We take a brief look back in history to see if we can gather any insights about the potential tapering ahead of us and what it means for investors.

Blog | 09.08.2021

How Does Inflation Impact the Luxury Goods Market?

by: Yiting Liu CFA

Is strong pricing power enough to battle inflation? Learn how the luxury goods market has defied odds by raising prices during a pandemic and in a post-pandemic inflationary period.


Back to top