Has your Income Portfolio become more Volatile?

Interest rates are low and many expect interest rates to remain so for longer. Investors looking for higher yields have to look elsewhere and away from high quality sovereign bonds and investment grade bonds. In recent years many investors increased their exposure to high yield bonds in order to keep their income returns in the mid-single digit range. While this move may have helped these investors to reach their income objective, some might have ignored the higher expected risk that such an allocation will add to the portfolio.

Bond investors should always be aware of the added risk which high yield bonds bring to the portfolio and be comfortable with that risk before increasing the portfolio’s exposure towards this sub-asset class. As expected, the high yield bond market has generally generated higher yields compared to safer alternatives. However, as global central banks embarked on ultra-loose monetary policy just over a decade ago, income returns in the high yield market declined to levels not seen before.

Bond investors have to keep in mind the role of different bond classes in a portfolio. Historically, good quality or investment grade bonds have generated both income and protection against volatile equity markets. Before and during the first years after the global financial crisis of 2008, decent income returns encouraged bond investors to have a higher weighting in investment grade bonds. This, given the low default risk that the asset class has had over time. With yields declining to record low levels both on sovereign debt and high quality corporate bonds, the level of downside protection or portfolio insurance against volatile equity markets has weakened significantly. This is true across short and medium-dated high quality bond issuers. Investors can find higher yields and downside protection from volatile equity markets in longer maturity bonds. However, this also exposes their portfolio to higher duration risk.

While the role of investment grade bonds is dual in nature, as explained above, to generate both interest and protection, high yield bonds generate more of the former and much less of the latter. High yield bonds are riskier type of bonds and have generally exhibited strong correlations with the equity markets. That is, when market sentiment is positive and equities rise, high yield bond prices tend to rise (yields decline) and vice versa.

Therefore, it is very important for investors who hold multi-asset portfolios to understand what type of bonds they hold in their portfolio. Those who fail to understand that different bond classes have different risk profiles argue that their fixed-income allocation has become more volatile. This is true if their current fixed-income allocation contains more high-yield bonds than it used to.

While today it is natural for income seeking investors to hold a higher portion of high-yield bonds compared to what they held in the past, it is important not to underestimate the risks which come with this sub-asset class. Traditionally, local investors had a tendency to invest in this sub-asset class by holding individual bonds. More often than not, the high income returns on such bonds enticed investors, but who gave little notice of the risks involved, namely default, liquidity and country risks.

The good news is that the global high-yield bond market has evolved and the asset management industry has come up with strategies which help both experienced and less experienced investors to gain exposure to the asset class while reducing significantly the risks mentioned earlier.

As interest rates on safer assets headed south, the high yield asset class has gained prominence and attracted more investors and bond issuers from different sectors. Investors should access the high yield bond market through diversified strategies in order to reduce the default risks associated with individual high yield names. Similar to other diversified strategies, a high yield bond strategy will invest across different bond issuers with limited exposure to a single issuer and any particular industry. These diversified strategies usually aim to reach the income objective but keeping risk in check at all times and avoiding problematic issuers and sectors in the process.

So while investors are comfortable with holding direct positions in investment grade bonds, ideally the allocation to direct high yield bonds is kept to a minimum. Exposure to the sub-asset class should be gained through diversified strategies.

The high yield bond market has had its fair share of negative weeks during the initial weeks when the pandemic first occurred in the western world. As all asset classes declined, the high yield bond market was among the hardest hit as investors fled the riskiest assets and sought shelter in the safest assets, such as sovereign debt, gold and cash. However, as market sentiment improved and equities rose, so did the high yield bond market. An index of global high yield bonds has generated 33% at the time of writing, since the lows reached during the last few days of March.

So while the high yield bond market is expected to meet investors’ income expectations, investors should always keep in mind that this bond sub-asset class has different characteristics than safer sovereign debt and investment grade bonds. As stated earlier, both equities and high yield bonds tend to be strongly correlated. Therefore, it is paramount for investors to understand the benefits of a multi-asset strategy while appreciate and understand the objectives and the risks of their high yield bonds exposure. As long as the high yield component fits within your risk tolerance, than your portfolio should not keep you up at night.

Gabriel Mansueto is the Head of Investment Advisors at Jesmond Mizzi Financial Advisors Limited. This article does not intend to give investment advice and the contents therein should not be construed as such. The Company is licensed to conduct investment services by the MFSA and is a Member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company, and their clients are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For further information contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta, on Tel: 2122 4410, or email [email protected]