Getting the right yield diversification for your clients

Supported by
AXA Investment Managers
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Supported by
AXA Investment Managers
Getting the right yield diversification for your clients

Navigating yield in order to build a truly diversified portfolio is a challenge for many bond investors, which is where an adviser may come in.

But why exactly should advisers be so concerned with ensuring their clients have a diversified portfolio of fixed income assets?

There are numerous benefits that come with having a diversified portfolio, regardless of the asset class. 

Investors may more commonly associate diversification with equities, making sure their portfolio is invested across regions, sectors and market capitalisation, for example. However, a similar approach also applies to bonds.

In fixed income being diversified across regions and types of credit can help spread the level of risk the client is exposed to and help achieve the desired return.

In the context of strong earnings and low default environments, we still believe that fixed income represents good relative value against most risk asset classes. Martin Horne

Martin Horne, head of European high yield investments at Barings, acknowledges: “Diversification of a credit portfolio is a good idea, in our opinion, regardless of the economic environment. 

“A diverse portfolio, for example, can help counteract unforeseen corporate or industrial underperformance, such as the relatively recent commodity cycle market movements.”

He continues: “In the context of strong earnings and low default environments, we still believe that fixed income represents good relative value against most risk asset classes.”

Risk and return

Mr Horne reasons if economic growth continues, spread tightening will provide capital appreciation potential to a bond portfolio. 

On the other hand, if economic conditions deteriorate, the low interest rate environment will likely be extended and spreads may widen to offer greater return potential.

Nicolas Trindade, senior portfolio manager at AXA Investment Managers, suggests optimal diversification “is about striking the right balance between risk and return”.

“You want to benefit from low volatility and drawdowns but also get the best yield achievable, which means you may have to compromise on yield to target attractive risk-adjusted returns,” he says.

Investors have been starved of yield for some time – another reason for diversifying away from a single source of yield in portfolios.

David Stubbs, global market strategist at JPMorgan Asset Management, points out many investors have been searching for yield beyond the bonds issued by their domestic governments.

“Correlations between government bonds remain high, meaning that investors can step out of their domestic market into higher yielding ones, such as New Zealand and Australia, with only a small chance that those markets will perform differently from their own,” he says.

“The next step is to consider fixed income sectors with radically different drivers from government bonds. Those include the parts of the fixed income universe which perform well when the economic picture is strong.

“They include corporate bonds, particularly high yield, and also bonds issued by the governments and companies of emerging markets.”

Getting the right combination

But Mr Stubbs reiterates: “As with most things in investing, all these fixed income sectors work best when combined with one another. Choosing the right amount to place in each type of fixed income, let alone the exact exposures within those sectors, is a challenging task.”

One way to achieve diversification is to invest directly in a bond fund, which takes the decision-making process away from both the adviser and their client, leaving this aspect to the portfolio manager.

With yield curves flat and a growing expectation that rates will rise, there can be a greater downside risk associated with investing in long duration bonds. Nicolas Trindade

Some bond portfolios are also designed to suit clients and investors with different risk requirements.

Ben Willis, head of research at Whitechurch Securities, explains: “Managing the bond conundrum, as we term it, is as important as ever as we potentially move into a new economic phase of inflation and gradual growth.”

However, he does not expect this to be either a smooth or rapid transition, which is reflected in Whitechurch's own funds by diversifying bond exposure as much as possible.

Mr Willis says: “For our clients, we have created a complementary and diverse basket of bond funds for cautious and balanced portfolios, especially income-focused strategies. 

“To try and mitigate a number of outcomes, our bond positions are allocated to various areas of the bond markets. Exposure ranges from index-linked gilts and investment grade credit, through to strategic bond exposure, short duration high yield and European bank paper.”

He adds: “It is via this approach that we hope we are able to provide healthy, income-driven risk adjusted returns within an uncertain outlook for bond markets.”

Duration positioning

For Mr Trindade, any diversified fixed income portfolio should have some exposure to short duration as a short duration strategy can be one way to play fixed income when interest rates are likely to increase.

He believes investors should be considering a short duration strategy as part of a wider balanced investment portfolio.

“With yield curves flat and a growing expectation that rates will rise, there can be a greater downside risk associated with investing in long duration bonds,” he cautions. 

One should diversify across countries, as opposed to within countries, as monetary policy, and therefore the behavior of risk-free rates, is diverging.Salman Ahmed

“Additionally, taking a global approach (in terms of regions and also credit ratings) allows bond investors to potentially benefit from specific opportunities in local markets, such as the US energy sector, the UK’s securitised debt market and Europe’s subordinated debt market.”

Taking a global approach to getting fixed income exposure also helps create opportunities, or at least means investors are less restricted by geography or credit type.

Fraser Lundie, co-head of credit at Hermes Investment Management, observes: “After a strong period for global credit returns, the scope for higher-risk companies to rally much further has diminished.

“We believe that interest rate volatility and the gradual winding down of quantitative easing programmes will introduce some hesitation into the credit markets but there is no shortage of opportunities within global credit, such as high-quality cyclicals and US retail.”

A diversified portfolio can be a suitable way for both first-time investors and those with years of investment experience to allocate to bond markets and help protect on the downside.

As Salman Ahmed, chief investment strategist at Lombard Odier, reiterates: “One should diversify across countries, as opposed to within countries, as monetary policy, and therefore the behavior of risk-free rates, is diverging. 

“In addition, we would reiterate that diversifying across different sources of risk – credit risk, interest rate risk, illiquidity risk and alternative risks, such as those accessible through insurance-linked securities – is critical.”

eleanor.duncan@ft.com