Asset allocation: Finding yield in volatility
How do investors achieve high yields while shielding their portfolios from global economic uncertainty?
For several months now, fixed income investors have faced a cruel dilemma between the search for yield and the need for safety. So how can they manage to square the circle?
This predicament became even more complicated recently with short-dated bond yields in several European countries moving into negative territory. It shows that when the economic environment is troublesome, many investors still trust governments with their savings, in spite of widespread and significant increases in government budget deficits and ratios of government debt to GDP.
It also reveals that, with a lot of uncertainties remaining, it is not only the traditionally defensive investors that are investing in bonds.
Bonds increasing in popularity
Flows on the equity side remain thin as investors are not yet convinced that political and economic unrest will alleviate soon. Moreover, Solvency II and Basel III regulations, which increase the cost of capital for holding risky assets, are pushing institutional investors such as insurance companies away from equities into bonds. As a result, the relatively safe and higher yielding parts of the fixed income universe become quite crowded.
Currently, core government bonds offer low yields. For example, the 10-year German bund has been trading between a yield of 1.16 per cent and 1.6 per cent for several weeks. It is therefore unsurprising that high yielding bond categories such as corporate investment grade, corporate high yield and emerging market bonds remain the most favoured fixed income categories, enjoying large inflows. But most investors, be it retail, wealth managers or institutions, have also always preferred a substantial share of ‘safe’ assets in their portfolios, traditionally represented by developed market government bonds. Historically, these bonds have provided protection during periods of stress.
The current situation points investors towards adopting portfolios that clearly distinguish between the safest assets and more risky ones, and that dynamically allocate between both. At the same time, investors must consider two other objectives: preserving their capital and delivering a total return above cash. Contrary to the traditional approach to investment – trying to generate returns in competition with, or in relation to, a benchmark – risks have to be taken only when rewarded, not when the benchmark dictates they are taken. Assessing and monitoring risks is crucial – and not only for the most risky assets.
At present, absolute safety is no longer warranted, even in the world of core government bonds. Any static allocation to one or to a fixed number of core government issuers will no longer be trusted to both preserve investors’ capital and diversify their portfolios.