Focus on risks, not assets

To our surprise, actuaries have consistently been advising little investment in credit instruments, or bonds issued by companies, despite the breadth of the credit markets and the number of funds available in the IA Sterling Corporates or IA Sterling High Yield sectors.

When questioned, actuaries have always given the same answer: the combination of government bonds and equities is stronger than credits on its own, due to the diversification benefits from mixing two asset classes with different risk premia. 

The risk of default needs to be assessed before investing

It is fair to state that investment grade and high-yield bonds are strange beasts in that they can be qualified as hybrid. First the returns on those instruments depend on the interest rate levels. The duration risk must be taken into consideration, as with government bonds.

But they are not only a duration play as these bonds are issued by companies. The risk of default needs to be assessed before investing. This credit risk is very similar to the equity risk as both depend on the profitability of the issuing company. 

Nevertheless, investment grade and high-yield bonds are not comparable in every sense, although they both exhibit duration and equity risk. A high-yield bond is a bond with a lower credit rating than investment grade corporate bonds (below BBB or Baa).

The risk of default is therefore higher, as is the credit risk. It means that the main driver of returns for a high-yield bond will be the profitability of the company, as the company risk is higher. Conversely the duration (or sensitivity to interest rates) is lower for high yield.

This trend is demonstrated in the chart below, which display the sensitivity to an investment grade and high-yield index to equity and government bond index. 

To compare a credit portfolio with a portfolio made of government bonds and equities, it is necessary to ensure both portfolios have the same level of duration and equity risks.

Take the case of the IBOXX UK Sterling Non-Gilts index, as a proxy for a credit portfolio. Historically, the duration of this index has been 0.85 lower than the FTSE UK Gilts All Stocks index.

The chart below shows a portfolio with an 85 per cent allocation to UK Gilts and a 15 per cent allocation to the FTSE All Share index, and its performance. 

Unsurprisingly, the returns have been similar as we have decided to neutralise the two main risk factors. Both the credit and the mixed gilt/equity portfolio have the same level of duration and equity risks, but the benefits of diversification should be reflected in the risk metrics.

This is not the case. The credit portfolio has a lower volatility over the past five years (4.72 per cent annualised v 5.47 per cent). Downside risk metrics lead to the same direction: the maximum drawdown is better for the credit portfolio (-6.52 per cent v -7.22 per cent) for example. 

This study provides several insights into asset allocators. The traditional approach to building a mixed asset portfolio puts the emphasis on the physical allocation between asset classes. Rightly so, this approach has been surpassed by the modern approach based on factor risks.

It is not about how much an asset allocator needs to invest between government bonds, credit or equities. The right approachshould be on how much an asset allocator wants to devote to the duration, credit and equity risks. 

Charles Younes is research manager of FE