InvestmentsMar 21 2023

The right time to construct a diversified fixed income portfolio

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The right time to construct a diversified fixed income portfolio
Photo: Nataliya Vaitkevich/Pexels

Bonds have to a large extent reverted to their historic role within portfolios as rising yields mean they can provide an income, and potentially diversification from equities if economic growth slows.

But the challenge from a portfolio construction point of view may be that while bonds are currently on a path that the textbooks imply they ought to be, the journey for investors in the asset class over the past two or so years has been acutely volatile, and heightened volatility from the fixed income allocation is the opposite of what many multi-asset investors anticipate from their bond portfolio. 

Fahad Hassan, chief investment officer at Albermarle Street Partners, says: “Last year was a test of nerves for income investors as they discovered the downside of fixed income duration.

The yields on investment-grade now are around 5 per cent, and when they are at that level I’m sure one needs to go anywhere else if yield is the priority.>---Michael Walsh, T Rowe Price

"As yields ratcheted higher, average duration [six to eight years] in benchmark allocations became a source of considerable volatility and drawdown.

"Investors who failed to shift to shorter duration or alternative allocations saw severe losses.”

But while it was tough to make money from a passive exposure to equities, Morningstar’s director of manager research Jonathan Miller notes that actively managed bond funds were marginally more likely to outperform relative to the index in 2022.

He attributes this to the fact that bond managers who simply switched to shorter-duration assets would likely have outperformed as the index is quite long-duration in nature, and no further stock selection skill would necessarily have been needed. 

Hassan says: “Income portfolios should consider 2023 as a more favourable environment for duration as global bond yields seem close to peaking.

"While shorter duration fixed income allocation still stands to benefit in a falling yield environment, they are likely to see smaller gains than the benchmark.

"It is therefore important for asset allocators to own benchmark duration exposures in government and investment-grade allocations.

"Inflation-linked bonds faced severe drawdowns in 2022 as rising yields more than offset the benefits of rising inflation.”

He continues: “As we enter 2023, inflation-linked debt faces a challenging backdrop as investors face the risk of a sharper fall in inflation, which could undermine the attractiveness of the asset.

"UK inflation-linked debt faces the added disadvantage of currency-driven swings. This adds additional volatility to an already challenging backdrop for this asset.

"In terms of riskier parts of the fixed income market – (high-yield debt, emerging market hard currency, emerging market local, financial subordinated debt and collateralised loans), there are some attractive yields on offer, and a diversified risk-controlled allocation to high-yield and EM dollar debt can be justified based on the implied default rates and the yields being offered by the asset class.”

Changing times 

For Eugene Philalithis, head of multi-asset management in Europe for Fidelity, the fact that bond yields have risen sufficiently that the asset class could now be expected to perform differently to bonds means that “it is possible to construct portfolio with a decent income yield using a mix of asset classes that are not excessively risky. That has not been possible for quite some time.

"Government bonds have a greater role to play now than they have for years, as they are the real diversifiers within portfolios.

"And I think that in the medium term, portfolio returns will be more variable, with some periods of very high returns and some of lower returns, and that is the sort of environment where people want to own diversifying assets”.

Guillaume Paillat, multi-asset manager at Aviva Investors, says one way to manage the volatility is to increase bond exposure at a time when the diversification role they play is likely to be most needed within a portfolio. 

He says that with concerns around the trajectory of the global economy, “when the shocks have happened, when we move from the inflation shock to growth shock, that is when bonds can do their job, and this represents a change from recent years when the correlations between asset classes was more tricky”.

With regard to where to allocate within the bonds universe, Michael Walsh, a multi-asset investor at T Rowe Price, says: “You can invest in areas such as emerging market debt and high-yield debt, and the yields there are quite attractive – to some extent that is because those are relatively less liquid asset classes.

"But to be honest, the yields on investment-grade now are around 5 per cent, and when they are at that level I’m sure one needs to go anywhere else if yield is the priority.” 

James Klempster, deputy head of the multi-asset team at Liontrust, places this shift in the bond market into context, remarking that one can now get 3 per cent on low-risk government bonds, whereas until this year, to get a yield of 3 per cent, one had to own corporate bonds, which are higher risk.

But he is more cautious on the investment case for high-yield bonds, taking the view that one needs to be very selective in that part of the market due to the enhanced risk levels.

David Coombs, head of multi-asset funds at Rathbones, says that in the current uncertain economic climate, owning bonds with a short date to maturity offers some protection against higher interest rates, while owning bonds that incur less credit risk may be the best value option right now, given the prevailing economic uncertainty.

Hugo Thompson, multi-asset investment specialist at HSBC Asset Management, says: "While the most appealing yields are in lower rated bonds, our portfolios are focused on higher quality credit markets; motivated by our near-term cautious outlook on the global economy.

"We see potential for yields to fall towards the end of the year."

David.Thorpe@ft.com