When considering the role of fixed income in a diversified multi-asset, multi-sector portfolio, the primary focus is to provide a stable source of return while serving as a diversifier to the riskier equity allocation, which is likely to be the leading driver of total returns over the long term.
With yields at or near record lows, bond investors worldwide are now faced with the risk of a reversal of this trend.
Furthermore, due to issuance stemming from the global financial crisis, the proportion of interest rate-sensitive governments in bond indices has been increasing. For holders of sovereign debt, rising rates could lead to capital losses, especially for bonds with longer duration as they have greater interest rate sensitivity.
For holders of corporate bonds, rising rates often lead to a contraction in spreads between the yields of sovereign bonds and credit securities, which can be bullish for corporate debt. Even for credit investors, however, rising rates can still be a threat because spread tightening may not be enough to entirely offset the negative effect of rising rates.
‘Safe haven’ fixed income securities tend to offset equity losses during market stress. With no clear line of sight of the exact timing and magnitude of the anticipated rate changes, any reduction in fixed income allocation could therefore prematurely leave a multi-asset portfolio vulnerable to geopolitical volatility.
However, diversifying within a fixed income allocation can alleviate some risk.
For example, through exposure to absolute return and floating-rate strategies as well as seeking out low or zero-duration share classes.
Absolute return strategies should ideally consider combinations of outright long and outright short duration, credit and currency exposures across both developed and emerging market debt. In addition, the ability for rapid responses to unexpected market changes is essential where effective shorting capabilities can exploit market conditions unfriendly to investors of long bond.
Cautious investors should expect some negative periods, particularly at turning points in interest rate and credit spread trends. Pay-off expectations should be lengthened to the medium term or three-year timeframe.
Floating-rate funds provide exposure to variable rate securities, primarily leveraged loans (bank loans) and asset-backed securities. These instruments are generally immune to the negative impacts of rising rates and may even benefit in such environments. Investors considering an allocation to this fixed income segment should be mindful of their lower credit quality, overall liquidity and regulatory restrictions.
While any silver bullet proposition has the potential to be fraught with disappointment, the urge to succumb to avoidance can be equally perilous. Therefore, adopting a Swiss-army knife approach utilising different interest rate-sensitive methodologies to weathering a variety of rising rate and credit spread widening environments can be the most prudent form of defence.
Iheshan Faasee is client portfolio manager at Russell Investments
