In the first two months of 2016, spreads across a number of fixed-income sectors widened dramatically only to reverse trend and narrow significantly by the end of April. This brief window is just an example of the unexpected and sometimes bewildering challenges facing fixed-income investors over the past three years. From the time when the Fed first began withdrawing its unprecedented stimulus measures in 2013 through to its December rate hike, the first of this cycle, the Fed’s efforts have been an exercise in brinksmanship with volatile and uncertain global markets.

As the Fed continues on its path to normalize rates, we believe investors need to think outside of index constraints. One way to insulate portfolios from future rate hikes is through allocations beyond U.S. Treasuries and traditional spread sectors — into sectors such as high-yield credit and, in particular, securitized mortgage debt. These securities provide diversification benefits without the need to sacrifice yield or expected return.

Historically low correlation to many sectors and asset classes

Historically, when the Fed has raised rates, Treasury rates have tended to move higher, and the Treasury yield curve has flattened. In such environments, spreads for other sectors of the fixed-income markets (mortgage-backed securities (MBS), investment grade, high yield, corporate debt, etc.) have generally tightened as a reflection of a stronger economy.

This rate-hike cycle might well be different, as the Fed has shown a reluctant willingness to consider global market volatility as a factor in its decisions. But for those investors who consider Treasuries and traditional spread sectors at risk, our research has shown that mortgage-backed securities offer excellent diversification benefits.

Non-agency residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), and various prepayment strategies, including interest-only (IO), that are available in the agency collateralized mortgage obligations (CMO) market have proven over time to have a low correlation to both corporate credit-related securities (investment grade and high yield) and emerging-market debt, as well as equities. Unlike the various subsectors of the credit markets that have been shown to have a relatively high correlation to equities (i.e., 0.40 to 0.70), the subsectors of the mortgage market have much lower correlations (i.e., 0.00 to 0.25).

In our view, these correlation data indicate the presence of systematic securitized risk factors that differ from those found in various types of corporate credit risk.

In addition, these mortgage strategies — RMBS, CMBS, and IOs — all have low correlations to each other, indicating that investors may benefit by including all three mortgage-backed security types as part of a broad fixed-income portfolio.

We believe the risks in these sectors look attractive from a relative value perspective and for building a more diversified portfolio. In today’s environment, as the Fed embarks on raising interest rates, the low correlations of these strategies can help to build greater resilience into a portfolio.