Fixed Income 

Prepare for the unpredictable

Prepare for the unpredictable

Traditionally, fixed income plays an important role as a risk dampener in a portfolio, as well as providing income, liquidity and return. 

However, in the years following the global financial crisis, some investors were reaching for yield by shifting their bond allocations towards higher-yield funds or towards flexible fixed income strategies. 

Market sell-offs always trouble investors, and often prompt a rethink of asset allocation decisions.

When considering fixed income exposure, a key question to ask is whether it is providing adequate protection from equity market volatility.

While a shift towards higher-yield funds have benefited some portfolios in the short term, as the macroeconomic environment evolves and accommodative monetary policy comes to an end, investors are now questioning whether such an approach is suitable for the long term. 

Since the crisis, central banks in the US, UK, Japan and Europe embarked on extensive quantitative easing programmes to support their economies.

Key points

  • Fixed income has historically been a risk diversifier in a portfolio
  • Investors have been piling into high yield to get better returns
  • They may not be getting adequate compensation for the risks they are taking

 

They built up their balance sheets by buying government, corporate and securitised market debt.

They also lowered interest rates in an attempt to stimulate growth. These expansionary policies led to two key outcomes for the bond market: a fall in yields and a tightening of credit spreads.

 

Essentially this is indicating that investors are getting less compensation for the risk they are taking. 

This in turn led investors to reach for yield and take on more credit risk, as they move out of higher-quality investment grade asset classes and into lower-quality high yield investments.

Flexibility could be risky

Investors have also turned to flexible fixed income funds as they look to navigate the uncertain interest rate and volatility environment. These funds typically have sizeable allocations to high yield to boost returns. 

This shift could be seen in high-yield fund flows, which markedly increased in 2016 and 2017. 

Why is this a cause for concern now? 

While some quantitative easing remains in place, accommodative policy is coming to an end. As the global economy continues to grow, we expect interest rates to normalise and volatility to increase. 

As this happens, risk –which has fallen due to accommodative policy – could increase and revert to historical levels.

In effect, investors who have sought yield or moved into flexible bond strategies may be unaware of how much risk they are taking on.

They could be in a position where their current fixed income exposures (to areas such as high yield) may not meet their long-term strategic objectives.

Fixed income diversity

What does this mean for current fixed income allocations?

The traditional role of fixed income in a portfolio is to provide diversification away from higher-risk asset classes, namely equities.

However, the fixed income universe is diverse, and different bonds have different levels of risk. High quality government bonds, such as UK gilts, are typically considered to be risk-free, whereas a corporate bond may have a risk profile more similar to that of equities.