No prize for stating the obvious but, as 2020 enters its final quarter, portfolios must be differently positioned to how they started the year. Central bank and government responses to the pandemic necessitate a rethink of the cautious strategies favoured by many retired investors.
“Many cautious portfolios are linked to success or failure of government bond markets and right now government bonds are extremely expensive,” says Thomas Becket, chief investment officer at Psigma Investment Management. That leaves seekers of low-risk income with a serious conundrum.
Quantitative easing (QE) programmes and ultra-low interest rates mean yields on quality government bonds (which move inversely with prices) now lag inflation. Furthermore, less scope exists for sovereign bond prices to rise and offset falls in other assets such as shares, diminishing a cornerstone of portfolio diversification.
As if this wasn’t bad enough, there is also medium-term uncertainty about inflation. For now, there is rightly much talk of the deflationary pressure lockdowns place on the economy, but in a recovery further down the line, the impact of massive stimulus programmes could be inflationary. Even a small rise in interest rates to counteract this would cause government bond prices to fall, causing pain for portfolios that hold a lot of them.
Weighing the uncertainty, Mr Becket opines: “As clearly evidenced at times in 2018 [when central banks last pushed to slowly raise interest rates] government bonds could be the dominant negative risk factor of your portfolio, rather than a hedge on your growth assets. That’s a new dynamic that we need to think about.”
Partly, that means lowering return expectations, with investors accepting spectacular asset-price rises in the 2010s are unlikely to be repeated. Opportunities are harder to come by in the new tougher environment, but do exist for investors who act swiftly.
Getting the right balance between rates and credit
As the real return from government bonds, or rates, has declined, strategic bond funds are pivoting more towards corporate credit. Lower-grade, high-yield corporate bonds aren’t appropriate for cautious investors, but better-quality investment grade credit has an important role to play.
It’s not just default risk to watch out for when considering a bond manager’s portfolio, however. Bonds that offer low coupons (the regular fixed amount they pay investors), and/or have a long time until they mature, will suffer bigger price falls when interest rates rise.
Duration, expressed in years, measures this interest rate sensitivity and the extraordinary low-yield environment means that investors in long-dated bonds are being asked to take the most duration risk for the lowest rate of return ever. It’s hardly appealing when medium-term inflation can’t be ruled out.
Other market factors are at play, too. Mark Holman, chief executive and portfolio manager at TwentyFour Asset Management, says: "A lot of money has been flowing out of government bonds, because they are risk free and return free, and going primarily into investment grade credit. And this is the silent change that I'm worried about because as money flows away from government bonds, it will eventually probably push yields higher and on the flip side it will make credit spreads tighter. That's a really important dynamic that I don't think is going to go away for quite a long time."
Effectively, government bonds being so unattractive at this stage in the cycle could make for some pricing relationships that cause volatility in fixed income markets, especially rates. However, Mr Holman thinks that there is plenty of time for this to play out and there will be opportunities in credit as spreads tighten.
“I would hope that while this spread tightening happens, traditional rates markets see their yields go higher, which would be a very useful tool for bond investors to have in defence at the end of this new cycle. If they do not move higher then I think fixed income investors would need to be prepared for a market with a stronger credit bias, and position accordingly by not over-stretching in search for yield as the cycle ages.”
Advocating pro-cyclical exposure but without taking excessive credit risk, on low-grade bonds or sectors such as travel and leisure that have born the economic brunt of the crisis, Mr Holman highlights opportunities. These include financial companies (which are far more stable from a fixed income perspective than after the banking crisis 12 years ago); unsecured bonds in fundamentally sound companies; corporate hybrid bonds (for example in utility companies); emerging-market bonds in stable sectors; and adding some higher duration in corporate bonds where the credit quality is good and the yield offers adequate compensation.
So, investors are having to think differently about risk and reward, but there is no need to despair. At the asset allocation level of portfolios Mr Becket upholds the core principles of diversification and looking to reduce portfolio correlations. At the security selection level, he champions strategic and innovative managed fixed income portfolios; some exposure to inflation-linked bonds; gold; and thematic equity funds in fields such as healthcare and infrastructure that offer combinations of lower volatility, inbuilt inflation protection and secure income.
