Bond portfolio management in 2020
In the context of income-oriented investing, we like the dynamic strategy that combines return-oriented credit assets – high-yield corporate bonds, emerging market debt and high-quality government bonds.
Historically, this is a good way to generate income while reducing downward volatility of the portfolio, especially valuable at the late stage of the credit cycle. This is mainly due to the fact that return streams generated by individual types of debt instruments are usually negatively correlated. The manager may change weights as valuations and market conditions change.
This allows the investor to reduce volatility without giving up excessive returns. To see what we mean, let’s look at some potential strategies.
The first is a portfolio of 65% of assets invested in US Treasury bonds and 35% in high yield bonds (debt instruments below investment rating with high profitability). This is a risk weighted strategy because credit is usually twice as volatile (volatility measured by the standard deviation of rates of return) than interest rate sensitive assets. Investors would have to maintain greater exposure to market interest rates to even out the risk weight on each side.
The second strategy is a 50/50 construction that excludes CCC-rated junk bonds – the most risky area of the high-yield universe. We call this risk managed portfolio.
Over the past 15 years, both strategies would easily outperform US government bonds and provide 75% to 80% annual return on high US yields. As the chart shows, both would have a better rate of return per unit of risk than US Treasury or high income bonds.
Chart: Compromise between return on debt and risk
(period of 20 years until 31/12/2019)
Historical analysis does not guarantee future results.
The aggregate is represented by Bloomberg Barclays US Aggregate Bond Index; US Treasuries is represented by Bloomberg Barclays USTreasury Index; high yield is represented by Bloomberg Barclays US High-Yield 2% Issuer Capped Index: high performance without CCC-rated instruments is represented by Bloomberg Barclays US High-Yield Ba/B 2% Issuer Capped Index: “barbell” strategy risk management represented by 50% of US Treasury bonds and 50% high yield without CCC, position rebalanced every month; risk-weighted “barbell” strategy is represented by 65% of US Treasury bonds and 35% high yield, rebalanced every month.
Data points represent 20 years on an annual basis.
Source: Bloomberg Barclays
In the face of declining credit cycles and / or an increase in geopolitical risk, the manager may restore the balance of the portfolio by reallocating towards higher quality and interest rate sensitive securities at the expense of the most risky credit market sectors. This makes the wallet smoother. After a wave of sell-offs on credit markets, investors can sell US sovereign bonds and other liquid assets and restore balance by reallocating higher risk assets at more attractive prices.
It makes sense to reallocate funds to higher-quality securities. We are observing a slowdown in production and cooling global GDP growth as well as an increasing risk of recession. The US credit cycle has been going on for the eleventh year in a row.
It is important to maintain the duration of the portfolio or exposure to sensitivity to changes in interest rates when there is uncertainty on the global geopolitical scene. During periods of market turmoil, the duration of treasury bonds serves as a factor neutralizing volatility in the stock and credit market, protecting the portfolio value from below.
When the US Treasury yield curve is flat, as is the case today, we think it makes sense to reduce the holdings of long-term bonds, such as 20- and 30-year US Treasury bonds. The yield of these securities per unit of duration is low compared to the yield per unit of duration in the intermediate section of the yield curve. Investors should consider focusing their exposure on bonds with a maturity of six to nine years.
Investors are not adequately rewarded for taking credit risk. Most credit assets are expensive today. On the US high-yield market, the average additional income (spread) compared to comparable government bonds was on average 3.4% as at December 31, 2019. This is well below the long-term average of 5.5% calculated from January 1, 1994.
In addition to government bonds, investors should combine exposure to high-yield corporate bonds with credit positions that offer an attractive combination of profitability and quality, such as for example subordinated debt of European banks and selected corporate debt with investment rating and emerging markets.
The subordinated debt of European banks was created in order to meet the Basel III global regulations, which required banks to build equity. Since these instruments have a lower position in the bank’s capital structure, subordinated bonds issued by investment grade banks offer a yield similar to that of speculative securities.
In fact, the yields on European additional Tier 1 (AT1) bonds exceeded those offered by high yield bonds in Europe and the USA. The debt of European banks is particularly attractive because European financial institutions are at a slightly earlier stage of the credit cycle than American banks.
Interesting are also BBB corporate bonds, which give income similar to those in the high yield market due to fears related to the risk of the status of “fallen angel”. Many of these companies prioritize debt reduction and still have good earnings.
Finally, among traditional high-income sectors, the pigeon slope of central banks with developed markets essentially supports emerging market debt.
Securitized assets in the portfolio can reduce volatility caused by geopolitical risk and be a solid link in sustainable strategies.
US mortgage-backed securities are more resistant to geopolitical risk than high yield loans.
You may want to consider more profitable assets on the mortgage strategy side, e.g. commercial mortgage-backed securities (CMBS) and Credit Transferable Securities (CRT) – a type of mortgage-related housing debt that is issued by US government-funded companies Fannie Mae and Freddie Mac.
Chart: American CMBs and CRTs securitized assets against HY Bonds
01.01.2018 – 30.11.2019
Historical analyzes do not guarantee future results.
CRT and CMBS are represented by selected sector bonds used in the construction of the investment portfolio, therefore they are not intended to represent a generally accepted proxy / indicator for these markets.
Source: Bloomberg Barclays
Complementary allocations to the credit and mortgage sectors can help you manage your portfolio’s return in the long run, as both sectors perform better over different periods. Securitized assets have low correlation with other fixed income sectors, including public debt and asset classes. This makes them a good portfolio diversifier.
Improving creditworthiness in most regions and lower interest rates should lower mortgage rates. Here’s another reason to consider adding exposure to residential properties in the US. A strong US labor market means that most borrowers can pay back mortgages.
As a result, we still see opportunity in CRT. These assets combine thousands of housing mortgages into individual securities that provide investors with regular payments based on the results of underlying (securitized) loans. Unlike typical agency bonds, CRTs don’t have a government guarantee, so investors can suffer losses if a large number of loans fail. The borrower’s solid financial standing makes CRT attractive – many of them have been upgraded to investment status.
CMBS can also increase portfolio revenues because they ensure a healthy increase in corporate bond yields. The sector has not enjoyed popularity in recent years, due to concerns about the retail apocalypse.
The need to find a way to maintain income flow while securing the portfolio against the full effect of higher volatility and slower growth is partly possible due to the right combination of loans, government bonds and securitized assets. The path is narrow and winding and ongoing geopolitical tensions and the slowdown in global growth will contribute to low and negative yields in 2020. The global slowdown may make the world even more vulnerable to adverse shocks, leading to further increases in volatility.
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The views expressed in this document do not constitute research, are not investment or commercial advice and do not necessarily reflect the views of all management teams. They change over time.