Adam Smears, Head of Fixed Income Research
Investors are wondering whether to fight it out in fixed income. Bond prices may be peaking, and low rates offer razor-thin income streams or negative returns after inflation. At the same time, investors’ needs and their yield requirements are the same as always.
Therefore, investor demand for yield has reinvigorated instruments that had previously fallen out of favour. Non-agency mortgages and collateralised loan obligations are even starting to issue again. Should investors flee from these increasing risks to other asset classes?
Pockets of yield offer some hope. Between the lows of 2008 and May 2012, European high-yield debt produced impressive returns for some investors who are willing to bear the extra risk that high yield debt entails, although such historical returns do not necessarily indicate similar future returns.
Risk diversification, however, is still hard to find. Historically, fixed income investors employing traditional beta strategies, i.e. gaining exposures from investing in different segments of the market, have benefited from a natural hedge between interest rate exposure and credit risk exposure. This diversification helped to minimise volatility and losses.
When the economy did poorly and interest rates fell, credit spreads widened, and gilts (British government bonds), US Treasuries and higher-quality corporate bonds performed well. When the economy began growing again, high-yield bonds and other instruments with higher credit risks did well. Either way, investors with exposure to both interest rate risk and credit risk likely earned returns.
That traditional hedge may no longer protect investors as well as it once did. Bond yields are at generational lows, and credit spreads remain tighter than their long-run averages. The limited upside for both credit and yields could make it more difficult to find diversification between them.
Most market observers, including Russell Investments, expect interest rates to remain low for some time. In addition, bond prices are expected to degrade moderately as quantitative easing pulls back and interest rates rise moderately from their historic lows.
Worse scenarios are possible: Central banks could raise interest rates significantly and bond prices might collapse, or a spending spree by European governments could create inflationary expectations and a selloff in bonds.
So how should investors diversify?
Investors should consider adjusting their core fixed income portfolios so they depend less on market returns (beta) and more on manager outperformance (alpha) versus the benchmark. While credit remains a sensible investment on relative measures, prudent investors should look to mitigate the risk of credit strategies selling off in response to rising rates.
Opportunities for alpha-orientated (absolute return) strategies exist in credit, foreign exchange and interest rates. Investors can also borrow ideas from hedge funds, which have succeeded in generating alpha through momentum, option-oriented and macro strategies. It is important to note that these strategies may not perform as expected and can lead to losses.
Today, option strategies appear particularly promising, with some option strategies providing exposure to movements in implied volatility, which are often inversely correlated to risky assets. If executed skilfully, these can be a good source of diversification but they can also lead to losses.
Another currently attractive investment strategy involves taking a short position on Eurozone corporate debt. Eurozone defaults have remained fairly flat since the beginning of 2011, even as economic growth has deteriorated. When GDP weakens, marginal companies often fail, but with monetary policy now propping them up, they may offer good value.
Finding yield in bonds is not hard, but even the most accomplished fixed income investors now find it challenging to diversify their risk exposures. One way they can do this is by making some allocation to alpha-orientated (absolute return) strategies. These strategies are less dependent on market levels to generate returns, and the wide variety of absolute-return strategies available provide investors with a more diverse source of returns.
Multi-asset investing does not assure a profit and does not protect against loss in declining markets.
Bond investors should carefully consider risks such as interest rate, credit, repurchase and reverse repurchase transaction risks. Greater risk, such as increased volatility, limited liquidity, prepayment, non-payment and increased default risk, is inherent in portfolios that invest in high yield ("junk") bonds or mortgage backed securities, especially mortgage backed securities with exposure to sub-prime mortgages.
The information, analyses and opinions set forth herein are intended to serve as general information only and should not be relied upon by any individual or entity as advice or recommendations specific to that individual entity. Anyone using this material should consult with their own attorney, accountant, financial or tax adviser or consultants on whom they rely for investment advice specific to their own circumstances.
Copyright © 2016 Russell Investments Group, LLC. All rights reserved.
First used: August 2013