Among the many challenges facing a multi-asset portfolio manager within the current market climate is what to do with one’s bond allocation. As readers will know, we at MitonOptimal fully subscribe to the view that diversification is the only free lunch in investing. As such, in order to stick to this principle, an exposure to fixed income is both a desirable (and perhaps even necessary) component of our models and portfolios.
With an estimated US$13 trillion of (mostly government) bonds – roughly a third of all in issue – offering negative returns and the rest of the asset class at record low yields, however, the risk / reward dynamic across much of the market is skewed very much towards the risk side of the equation. Indeed, the chart below, courtesy of JP Morgan, shows the impact of a 1% rise in interest rates on the returns from various parts of the bond market, based on 30th June prices and assuming constant credit spreads. By way of example, the owner of a ten-year Gilt would face a 17% capital loss in such a scenario (UK Gilt yields are, in fact even lower – and the potential negative impact therefore greater – at the time of writing). This illustrates all too clearly why government bonds, whilst not necessarily an accident waiting to happen, have been described by some commentators as “the reward-free risk”.
So where is it safe to invest within the bond space?
Away from the strategic (ultra-flexible, pragmatic “go anywhere”) managers that form the core of our models’ allocation, there are still parts of the bond market that offer both the prospect of relatively attractive returns and diversification benefits. Amongst these are residential mortgage-backed securities, both in the US and UK, where minimal duration, strong asset backing, attractive yields and floating rates tick many of the boxes, in terms of our current “wish list” for bonds.
Elsewhere, as shown by the right-hand side of the chart, both High Yield and parts of the Emerging Markets (EM) debt universe demonstrate the “power of carry”: clipping a coupon equivalent to 0.5% per month is a very powerful performance driver and stabilising influence, even in an inherently volatile asset category. Moreover, valuations are, in both relative and historic terms, not at all stretched and, as such, we see attractions and opportunity in these areas. In each case, however, and especially in EM, we advocate exposure through genuinely active fund managers, rather than an index-tracking or benchmark-driven strategy.
Finally, thanks to the wide powers afforded by UCITS legislation, the number of decent quality, liquid, absolute return (hedge) vehicles operating a variety of investment styles – macro, relative value, quant-driven strategies across sovereign, credit and / or EM – and offering the prospect of pure alpha generation, is growing steadily. These too can prove to be a very useful diversifier within a multi-asset portfolio.
The Bond Market Conundrum
