Elodie Laugel, head of client solutions development, multi asset class solutions, AXA Investment Managers
While “market buzz” has focused on the “great rotation towards equity” since the beginning of the year, another theme has been unfolding with investors increasingly allocating towards “non-traditional” and/or “alternative” fixed income.
Indeed, over the last three years, “non-traditional” fixed income assets have faced significant demand, and as a consequence, have also delivered strong returns; despite the prospect of QE tapering, which would logically lead to rising market yields, appetite remains high. Several reasons explain the continued attractiveness of “non-traditional” fixed income assets and why diversification towards these assets deserves attention.
Since 2007/2008, high market volatility and low interest rates have negatively impacted solvency for institutional investors, driving short-term risk aversion. Implemented in the current low yield environment, de-risking strategies effectively translate into high opportunity costs, whereas investors are in dire need of asset growth. The shy rotation towards equities observed this year demonstrates that risk-bearing capacity has not yet fully recovered; rather, the search for superior yield has been the focus.
The appetite for “satellite” fixed-income assets such as high-yield bonds/loans, insurance-linkedbonds, real-estate loans and “alternative” fixed income/credit strategies has been consistently rising. The rationale for such demand finds its base in the winning combination between higher yields than traditional fixed-income but lower risk than equities as well as in favourable regulatory treatment. In addition, fixed income “satellites” display appealing correlation features, with low correlations to government bonds and interest rates. While US Investment Grade credit shows a correlation with US government bonds of around 60%, fixed income “satellite” assets overall are far less synchronized, with correlations below 20% and even negative for high-yield bonds and high yield loans (respectively -25% and -16% on average).
On the other hand, correlations with (developed) equity markets are higher demonstrating the link of such assets to growth attributes. But these “higher” average correlation levels (between 20% and 65% depending on which satellite is considered) actually remain quite low when looked at from the perspective of diversifying equity-like exposures. The combination of higher yields and moderate correlations to pure equities contribute towards the construction of long term, robust portfolios.
For multi-asset portfolios, incorporating fixed-income “satellites” widens the view from focusing solely on the traditional trade-off between equities and core fixed income, providing a vast array of risk profiles and large diversity of return ambitions, market behaviour and liquidity profiles. It is essential to understand how best to incorporate these assets into a portfolio and how different levels of allocations can be made to fit different levels of risk appetite.
If a range of efficient portfolios is analysed, high-yield, emerging debt, and insurance linked-bonds always form a part, with different allocation reflecting differing levels of risk appetite. This demonstrates optimal diversification can be achieved regardless of an investor’s risk aversion, thanks to low correlation levels and an intermediate risk / return profile (between investment grade credit and equity).
It is true that in practice markets sometimes painfully remind investors that correlations are not stable, and fixed-income “satellites” do not escape the rule. In 2008, correlations with equity markets surged suddenly and, over the last five years, those correlations have been fluctuating.
While correlations can go through periods of instability, this should not discredit the benefits that diversification can bring to a portfolio over the medium to long run.
Markets are raising several important questions: what will be the impact of QE tapering on yields? Will shorter business cycles and reduced dealer liquidity lead to heightened credit volatility? These questions could indeed point to some short-term challenges. For investors with such concerns, liquidity constraints or who are simply more short-term focused by nature, a nimble approach is preferred, perhaps delegating investment in “satellite” fixed-income to active managers who can use flexibility of duration, asset universe and rating spectrum for example.
Such agility can enable short-term focused investors to reap superior yields while mitigating short-term market risks.
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