Markets Insight
August 13, 2014 8:10 am
Case for credit investment still stands
Problems of a low yield world prove value of diversification
Investors who hold a mix of equities and fixed income instruments such as credit and government bonds can still take comfort, despite the low fixed-income yields on offer across the developed world.
Although the price of bonds has been bid up in recent years, and the extra yield on credit – or credit spreads – is less padded than it has been, a fixed income allocation will continue to serve as a useful stabiliser during volatile market periods.
Many investors are rightly worried about prospects for fixed income. The rally in fixed income and the fall in yields over much of the past three decades was driven first by successful inflation-targeting policies and a decline in interest rates, later by a glut of emerging market savings looking for suitable investments, and finally by heavy monetary stimulus. Now it seems to be lacking a future driver.
Recent highs in government bond prices and questions over the future of US Federal Reserve policy may lead some investors to consider a more radical approach to their asset allocations. In a simplified world, investors may divine three choices.
The first approach, investing heavily in fixed income, seems doomed to failure. Recent risk-adjusted returns are unrepeatable. Over the past five years, US government bonds maturing in five to seven years have provided annualised returns of 4.4 per cent, with volatility of 4.5 per cent, a return-risk ratio of almost 1.0. Investment grade credit has returned 7.5 per cent, with volatility of 5.2 per cent, a ratio of more than 1.4.
To repeat such risk-adjusted returns over the next five years, five-year government bond yields would need to fall to below minus 1 per cent, and/or credit spreads would need to break record lows. And this is before we take into account the likely increase in fixed income volatility that will accompany monetary policy tightening from the Fed and others.
However, the second approach, avoiding direct exposure to interest rates altogether, is almost as extreme and probably equally ineffective. Equities have delivered average annualised volatility of around 15 per cent over the past five years, a level that seems likely to at least persist in the next five years. But with valuations now higher, prospective yearly returns seem limited to 7-8 per cent, with a return-risk ratio of 0.5.
Even holding a 50-50 portfolio of equities and floating rate debt would not help, as floating rate debt fails to diversify equity exposure as effectively as fixed rate equivalents. Floating rate debt offers investors a premium in return for its risks, but within a portfolio its characteristics are similar to cash, which fails to provide diversification benefits. As such, we would expect an equally balanced portfolio of equities and floating rate debt to offer a similarly disappointing return-risk ratio of 0.4.
On a risk-adjusted basis, the diversified approach still seems to be the most promising for investors. Equities and bond yields tend to be positively correlated. The mix of growth and inflation that drives bond yields up also tends to be good for equities. Equally, as the past two weeks have demonstrated, fixed income tends to benefit when stocks sell off.
The recent flight to safety helped drive 10-year US Treasury yields down to 2.4 per cent and 10-year German bund yields to 1.05 per cent, their lowest points in more than a year, helping protect diversified investors against equity market losses.
If the historic benefits of diversification persist, we would expect even a simplistic 50-50 portfolio of US fixed rate investment grade credit and US equities to deliver returns of 5.9 per cent, but with volatility of just 7.9 per cent, giving a return-risk ratio of roughly 0.7. This is better than either the pure equity portfolio, or the combined equity and floating rate portfolio.
Overall, investors should not dismiss fixed income as an asset class just because prospective returns are lower than in the recent past. Tailwinds in favour of declining rates are behind us and investors need to stop thinking of fixed income as a big driver of returns. But they should treat it as an asset class that helps protect against volatility. Despite low yields, the logic of a mix of equities and fixed income still holds.
Mark Haefele is global chief investment officer at UBS Wealth Management; Kiran Ganesh, co-writer, is cross-asset strategist
Copyright The Financial Times Limited 2014
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