Over the past 40 years, lower interest rates have become the norm across the globe, culminating in the ultra-low, and in some cases negative, interest rates we are seeing in some parts of the world today.
Savers in some countries now commit to receiving zero interest. For bond investors this means no income from their investment, ultimately forfeiting part of the purchase price of a bond if they hold it to maturity.
Government bonds have morphed from their historical role in portfolios as a source of risk-free return to now being a source of return-free risk. Investors should not be fooled by the high historical returns of some government bond funds over the last year or two. Investors allocating capital are concerned with the yield to maturity, which is a forward-looking measure that reliably predicts future returns for long-term holders of bonds. For government bonds, this yield is invariably now very low.
We will avoid the question of why investors continue to invest in products with such low (or even negative) yields. There are several potential explanations, which have little to do with the need retail investors have for a secure, long-term income stream and a need for defensiveness in a multi-asset portfolio. Thankfully, there are ways for these investors to navigate this challenging environment.
A QE WORLD
In March 2020, some investors discovered, to their detriment, that equity dividends are highly conditional on broader economic conditions, even in the case of so-called ‘blue-chip’ stocks. The abrupt reduction in dividend payouts, by what were previously considered reliable companies, will likely drive interest in fixed income from retirees. In contrast to equity dividends, the interest payments received from bonds are contractual obligations and therefore more reliable and predictable.
One misconception, which some investors have about bonds, is that fixed income equates to a capital price that is essentially fixed. That is, investors do not expect significant day-to-day volatility. This is incorrect: bond investments can be volatile.
Bond investors are exposed to two main risks: credit risk and interest rate risk. As with other asset classes, appropriate portfolio construction in credit is about assessing risk tolerance. A starting point is to ask, “How much of each of these risks can an individual investor afford to take?” Followed by, “Does the extra yield compensation being earned in higher risk bonds justify the increased risk being taken?”.
In March 2020, it turned out that some investors were being undercompensated for the risks they were exposed to in their credit portfolios. While bonds with interest rate risk did well, as mentioned previously, the interest rate risk of government bonds is now very poorly compensated. This leaves corporate bonds as the primary means of gaining exposure to secure income streams, while increasing the defensiveness of multi-asset portfolios. So, assessing the appropriate credit risk budget is key.
DIVERSIFICATION REMAINS CRITICAL
The bond investors who tend to be most undercompensated for credit risk are often those who build their own portfolios of individual securities. Credit is not an appropriate asset class to attempt to ‘pick winners’. Bonds with lower credit ratings pay higher yields because they are compensating investors for a higher risk of default, and detailed credit work is required to assess this risk.
In March, investors with holdings of individual bonds were once again harmed, with Virgin Australia becoming the latest local default story. Investors in a recent AUD Virgin bond issue did not even receive their first interest payment before the bond defaulted, destroying most (if not all) of the capital committed.
For bond investors it is possible to lose capital but in normal circumstances upside is constrained. This is because outside of a default situation, bond returns in the long-term are almost entirely explained by coupon income rather than capital price fluctuations. For this reason, it makes sense to invest across a large number of different bonds.
A well-diversified bond portfolio should include exposure to a number of sectors and regions to mitigate the downside if something goes wrong. A positive is that this sort of diversification doesn’t have the potential to reduce upside, because that upside is constrained in the first place. So, there is little downside to diversification in credit – it is just good risk management.
Investors who do diversify can earn their target yield without risking the loss of a large portion of their capital. As most individual investors do not have sufficient wealth to do this effectively, a number of actively-managed funds exist to provide opportunities for income to be earned in the most optimal, risk-aware way.
MANAGING DOWNSIDE RISKS
Yields in excess of government bonds and term deposits are available even from funds with quite conservative credit profiles, and so these are an ideal base from which to build a defensive, income-producing portfolio.
By contrast, funds investing in higher-yielding bonds have reduced defensive characteristics. Focusing on the US market where data availability is more plentiful, US investors have earned a 0.76% annual premium since 2010 for investing in investment-grade corporate bonds rather than equivalent government bonds.
For investors with a higher risk tolerance, it has been possible to earn a substantially higher 3.14% annual premium by investing in high yield bonds rather than government bonds. In addition, Australian investors in US bonds will typically have earned even higher yields by hedging their currency risk (because Australian interest rates have mostly been higher than US interest rates).
What sorts of risks are investors taking to earn these higher returns? Chart 1 below shows the volatility inherent in the returns earned in credit relative to government bonds.
Investors should determine whether they can ride out periods of weaker returns without compromising their overarching investment strategy. This question should, however, also be asked in the context of an entire portfolio.
In periods of market weakness, poor equity returns will dominate the returns of all but the most high-risk fixed income portfolios.
A sensible approach would therefore be to blend growth and defensive allocations appropriately to target an average expected return, in the context of a maximum tolerance for negative returns over a given horizon. Other issues, such as liquidity needs and other individual circumstances, can then be overlaid.
Investments in defensive funds like credit funds should then be undertaken on the proviso that the expected investment time horizon closely matches the recommended holding period for the fund. In other words, as an investor increases the risk they are taking, there should also be an upwards adjustment to the expected investment holding period.
THE FUTURE OF FIXED INCOME
What will investment portfolios look like in the future? Greater volatility is a sensible expectation across a range of markets, as allocations that have behaved defensively in the past may not be as useful going forward. Government bonds have lost their defensive efficacy – they now represent a ‘return-free risk’, rather than a risk-free return. Other potential defensive allocations will also become more expensive, in part because of generally higher market volatility and in part because of low interest rates.
Given the current environment, now is the time to consider an actively managed, high-quality credit fund as the most appropriate defensive building block for a
multi-sector portfolio.
Credit provides a historically attractive yield pickup over both cash and government bonds. It serves to remove reliance on insecure sources of income, like equity dividends, while increasing the defensive characteristics of the overall portfolio. In some cases, credit allocations may also increase the portfolio’s income yield.
In a QE world, it is easy to earn income by taking disproportionate risks but earning income in a sensible, risk-aware way is more challenging. The good news is the recent sell-off has provided an excellent buying opportunity for investors looking for a defensive way to earn income.
Justin Tyler is director at Daintree Capital.
