Global Head of Fixed Income Investment Strategists
Interest rates have been stubbornly low for years — a trend we think likely to continue. Although bond yields have risen compared with their lows of the past year, along with many investors, we’re skeptical of the case for meaningfully higher rates. As a result, investors are justifiably considering alternatives to fixed income that may offer more return potential.
But focusing on return alone can lead investors to overlook the critical role that fixed income can play in diversifying portfolio exposures. Developed-market sovereign bonds, particularly US Treasuries, have significant risk diversification benefits that can help to offset pain in risk assets. Furthermore, particularly for investors who have sought returns through exposure to illiquid private assets, the relative liquidity of public fixed income can help to efficiently implement portfolio asset-allocation shifts when market volatility strikes.
We also think it’s important not to overlook the potential for certain areas of the fixed income market, including emerging market debt, to provide meaningful returns and yield enhancement. Chinese bonds, for example, enjoy a yield advantage over the bonds of their developed market (DM) peers. The low correlations of Chinese bonds compared with DM bonds also suggests substantial diversification potential in a fixed income portfolio.
The longstanding presumption, borne out by fact, is that in periods of stress in risk markets, investors will seek the safe haven of DM sovereign bonds. Indeed, US Treasuries and the mighty US dollar represent the highest standard for risk-free assets. The resulting demand for US Treasuries drives yields down and prices up, which then diversifies falling asset values elsewhere in a portfolio.
As global yields approached and then fell through zero — a threshold that had previously been considered a floor — many questioned whether the diversification property of DM sovereign bonds would persist.
The data shows that DM sovereign bonds have indeed continued to be diversifying in this context. When we look at the negative interest rate era across developed markets, we notice something interesting: during the most significant fixed income market dislocation during this period (which took place in Q1 2020), US Treasury yields fell significantly more than those in lower-yielding European peer markets. US Treasuries were, in other words, more diversifying than other, lower-yielding sovereign bonds. Certainly the safest-haven status of US Treasuries was a benefit during this period; this phenomenon also took shape because the starting level for US Treasuries was elevated compared with other DM bonds. Figure 1 compares US Treasury bonds’ performance during this period, compared with German bunds and UK gilts.
Figure 1: Lower-Yielding Sovereign Bonds Have Offered Less Diversification Benefit Than US Treasuries
10-Year Sovereign Yield Changes When Equities Decline Less Than 5%
When yields are low and both the income- and total return-generating potential of fixed income are subdued, we believe every dollar invested in fixed income should be maximized. This leads to the case for extending the duration of US Treasury holdings in a portfolio in order to deliver maximum diversification benefit; doing so opens the door to consider a more capital efficient use of funds allocated to fixed income. In the most significant equity market sell-offs in recent memory (in 2008, 2011, and 2020), the corresponding rallies in long US Treasuries approached and even exceeded equities-market declines (see Figure 2).
Figure 2: Rallies in Long US Treasuries Offset Most Significant Equity Sell-offs
The asset allocation of the typical portfolio has evolved far beyond the 60% equities/40% fixed income standard of yesterday. Incorporating alternatives in a portfolio can bring many risk and return benefits but can also introduce liquidity constraints. The illiquidity of many alternative investments creates challenges for investors seeking to efficiently implement asset allocation shifts and to meet ongoing cash flow needs. Liquidity is usually a term connected to cash and Treasuries, but in the context of this investment landscape, we think liquidity should be considered in relative terms.
Take, for example, private credit and high yield fixed income. The draw of private credit for many investors stems from elevated income driven through a leveraged portfolio structure invested in private lending activities. The private nature of the investments means that assets are only periodically assigned valuations. Because these assets are not freely traded, the effect is a smooth return profile compared to investments that are regularly marked to market; however, private credit suffers from very challenged liquidity.
On the other hand, high yield offers elevated income driven through investment in leveraged companies. While there are certainly periods when accessing liquidity in high yield can be difficult, high yield is marked to market daily and in general high yield is much more liquid than private credit. These complementary properties suggest that using high-yield fixed income in combination with private-asset investments can provide investors with the best of both worlds: access to a diversified spectrum of high-income investments, capture of a liquidity premium, and the flexibility to trim or add exposure opportunistically.
This is supported by the long-term return outcomes realized in both high yield and private credit. While observed returns in private credit have been higher than those in high yield, deleveraging the returns on private credit and subjecting the returns to market volatility (akin to high yield) reveals that high yield is a quite strong proxy (see Figure 3). In this manner, the relative liquidity of high yield can improve portfolio risk characteristics of a “modern” portfolio that includes an allocation to private credit.
Figure 3: High-Yield Fixed Income and Private Credit Together Can Increase Portfolio Flexibility
Relative Performance of Public and Private Credit (Cumulative Return %)
Key Takeaways for Investors
Faced with the prospect of persistently low interest rates, alternatives to fixed income that may offer more return potential are understandably appealing.
Globally stimulative fiscal and monetary policies will provide support for spread sectors and the income they provide: corporate and structured credit, investment grade and high yield credit, and emerging markets debt.
We think investors may benefit from using allocations to DM sovereign bonds, especially long-maturity US Treasuries, to diversify risk exposures away from fixed income.
We believe liquidity should be thought of on a relative basis: For example, investors who have sought returns through exposure to illiquid private assets may particularly benefit from the relative liquidity of public fixed income, which can help to efficiently implement portfolio asset-allocation shifts when market volatility strikes.
An allocation to Chinese bonds can introduce both income and diversification benefits to a fixed income portfolio. Inclusion in major indices has broadened the investor base for Chinese bonds and created favorable demand technicals.
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