Yields have failed to rise in line with expectations, but bonds remain a crucial asset class for any investor building a yield-generating portfolio.
As the chart below shows, the approximate level and direction of change of bond yields over time is related to long-term economic growth rates, which go a long way to explaining why bond yields remain low today.
The improved macro trend of the last year or so suggests a bottoming out in the rate of nominal GDP growth and the consequent bottoming of bond yields. However, Chris Iggo, AXA Investment Management’s chief investment officer for global fixed income, warns against expectations of a massive rise in bond yields.
‘The consensus view is that yields are “too” low and that the tendency should be for them to rise, but by how much and driven by what? Sure, short-term considerations about synchronised global growth, the potential for fiscal stimulus in the US, the Fed’s tightening plans and higher headline inflation all point to higher yields.
‘However, if the longer-term trend is not towards higher rates of nominal growth, then the extent to which yields will rise is likely to be limited.’
He believes investors should think instead about what fixed income markets can offer investors today, in terms of helping prepare for tomorrow: ‘That is, as always, capital preservation, a source of income, total return opportunities and diversification against the promises of equity-driven growth. Bonds can be an investor’s best friend,’ he says.
Below, he reveals his six golden rules of investing for yield:
1. Set a realistic level of income
The right strategy for any income investor will depend upon their risk tolerance, which will dictate the maximum level of income that can realistically be achieved, and their investment timeframe.
‘First of all, you need to have some kind of plan in terms of your investment strategy,’ says Iggo. ‘This needs to be guided by a realistic level of income that you want to achieve and by when you will need the capital you’re investing.
‘The investment time horizon is important for setting the duration of your investment – are you happy to leave the capital untouched for ten years or will you want it back in six months’ time?’
This will likely impact how much short-term price volatility is acceptable for investors relative to their ongoing income needs.
2. Diversify your sources of yield
Having a diversified stream of income could mean having exposure to everything from government and investment grade bonds to high yield across developed and emerging markets around the globe. Other areas that income investors are considering include infrastructure debt and real estate investment trusts.
Diversification should also be achieved at an asset class and sub asset class level. A well-diversified bond portfolio, for example, may have 100 to 120 individual holdings with exposure to parts of the market that are boasting the best risk/return profile. At present, these include emerging market debt, high yield and financial corporates.
‘We’ve seen quite a long economic expansion, so you could reasonably expect some sort of downturn over the next five years,’ says Iggo. ‘Having a well-diversified bond allocation could help mitigate downside movements as this risk emerges.’
Inflation poses another risk to investors, and inflation-linked bonds are a key asset class for investors looking to prevent income from being eroded by inflation.
‘It’s important to be very diversified and not take concentrated bets; if something goes wrong with one investment, it won’t have too negative an effect on the overall portfolio. You need a large number of individual holdings to get diversification in each bucket.’
3. Consider short duration
In the fixed income space, a short duration approach has the potential of lowering the sensitivity to rising interest rates while maximising risk-adjusted returns and liquidity, relative to the all-maturities market.
‘If portfolio volatility is an important consideration, a short duration approach is best at this point in time, in our view,’ says Iggo.
AXA IM’s short duration bond portfolios are designed to have 20% of holdings maturing each year.
‘As well as the naturally attractive liquidity profile this creates, it allows us to reinvest the proceeds of maturing bonds in the best opportunities at the time. If yields are rising that plays in our favour,’ adds Iggo.
4. Understand your risk/reward profile
It can be tempting to take on more risk in the hunt for yield, but make sure you are not taking on too much risk for the rewards being received.
In bond markets this means avoiding extending duration in an environment of rising interest rates.
‘Putting more money into higher risk assets might seem fine at the moment, when the macroeconomic backdrop is quite benign, but could be quite risky should that change,’ says Iggo.
For example, yields on high yield debt – typically 3% on European high yield and 5.5% on US high yield – are not enough to compensate investors should defaults go from their current level of 2% to a more normal level of 5%.
Conversely, areas of the market that have a favourable risk/return profile, offering attractive yields from highly-rated issuers, include emerging market debt, subordinated financials and corporate hybrids.
Having a focus on long-term quality will ensure you are taking risk in the right way and can help to mitigate the impact of any adverse macroeconomic headwinds.
5. Avoid excessive trading
It’s important to have the flexibility to trade in and out of investments to take advantage of the best opportunities.
However, trading is expensive and can quickly eat into returns. This is especially true of bond markets, given the relatively low yields on offer at present.
‘The bid/offer spread is typically 30-40% of the yield, so if you trade too much, you’re paying away that spread, and that clearly reduces the overall return,’ says Iggo.
‘Maintaining a naturally short duration in portfolios by allowing short-dated bonds to naturally mature can also help improve returns as you’re effectively only paying one side of the bid/offer spread.’
6. Be aware of currency risk
Investing globally exposes investors to currency risk. High yield bond and emerging market funds, for example, are typically denominated in US dollars, but the underlying bonds they hold may have been issued in any currency.
Fund managers can either allow the currency risk to be part of the portfolio’s overall risk exposure as exchange rates fluctuate, or they can minimise this risk through currency hedging.
‘While non-hedged approaches can lift returns if currency movements are favourable to the portfolio, adverse currency fluctuations could easily overwhelm the underlying bond yields,’ says Iggo.
Keeping your capital as stable as possible will ensure your income stream is also stable – so investors looking to minimise this risk could be wise to consider funds that hedge currency exposure.
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