Interest rates are still very low, both in absolute terms and relative to historical levels over the past decade and before. Many bond market specialists have predicted rates will rise, but increases since the historically low levels of 2016 have been very limited in Europe.
Given the fact that the end of the ECB's Quantitative Easing program is near, we think that interest rates may indeed rise. On the other hand, a rise in rates will likely be limited due to long term factors like demographics. In this market of low yields in combination with these conflicting factors, the challenges of how to allocate capital are still very relevant. The article discusses four directions to consider in optimizing the risk-return profile of fixed income portfolios.
Written by Gerard Moerman of Aegon Asset Management and Franck Sega of La Banque Postale Asset Management.
1 & 2: Lower duration and/or higher credit spread risk
Many investors have already considered or implemented the first two directions: lowering duration risk and increasing credit risk. The lower duration will of course help when rates rise. Increasing credit spread risk can be done by allowing lower-rated investments or considering alternative fixed income strategies, such as convertible bonds, asset backed securities and emerging market debt. Increasing the amount of credit risk paid off in 2016 and 2017, but in the first half of 2018 we witnessed the first signs of problems as credit spreads, both investment grade and high yield, rose. Although these suggestions seem straightforward, there are a number of drawbacks that an investor should be aware of.
3: Look for flexibility through fixed income absolute return strategies
Another step is to allow oneself greater freedom in the bond market by investing in flexible products that tend to be weakly correlated with the traditional markets. Managers have the possibility of reducing or removing duration in the event of an anticipated increase in rates or spreads, or even taking negative duration positions. These so-called absolute return or target return strategies are gaining traction, especially in the wholesale market and for cash replacement purposes.
4: Capture illiquidity premiums
The fourth possibility discussed is favored by institutional investors who are often more willing to turn to illiquid bonds and loans in search of additional returns. These longer-term investments offer increased return potential, as they tend to have an additional risk premium reflecting the low liquidity. More and more investment managers are active in these illiquid fixed income asset classes which can offer exposure to different segments of the real economy and to the private real estate market.
Concluding, this article describes four possible directions in which to improve the asset allocation within fixed income. A suitable solution depends on a number of factors, such as the starting point of the portfolio, the view and risk appetite of the investor and, in case of an institutional investor, the liability profile. Our discussion intends to provide investors with ideas to consider, to find a solution that is suitable for them.