Download The role of fixed income in a multi-asset portfolio

Tim Cook, Senior Consultant
The role of fixed income
in a multi-asset portfolio
In a world where yields are paper thin, the natural question to ask is,
does fixed income still have a role to play in a multi-asset portfolio?
Our latest research paper answers that very question.
The paper works from the premise that bonds are expensive (yields
are low), the risks are asymmetric, and that credit exposure has a
higher correlation with equities than Treasury bonds and therefore
doesn’t provide the same diversification benefits.
From there it discusses the questions:
›› Has the role of fixed income in multi-asset portfolios changed given the
current low yields?
›› Does a higher correlation between credit and equities change the role
of credit in a fixed-income portfolio?
The paper summarises various related research papers, the positioning
of Russell Investments’ multi-asset portfolios, and strategic versus
current market views to get a holistic view of the issue.
It shows that after everything is considered, there are still strong
strategic reasons for holding both sovereign and corporate debt.
In fact, the strategic rationale for holding fixed-interest assets in a
diversified fund remains unchanged. The paper says fixed income
has demonstrated and delivered a lower-risk investment over time,
provided diversification from equities and thus a degree of protection
in equity downturns.
Fixed income has also delivered excess returns over cash and remains a
significant part of strategic and peer benchmarks.
The only rationale for exclusion or reduction, it says, must come from
current market views and expectations for future performance, and those
expectations need to outweigh the long-term strategic beliefs.
As a tactical decision, the size of the reduction would have to be weighed
against the inherent risks (be they peer, benchmark or nominal return
based) of such a move and scaled by the conviction in the view.
...fixed income has
demonstrated and
delivered a lower-risk
investment over time,
provided diversification
from equities and thus
a degree of protection
in equity downturns.
It would also be important to consider the upsides versus the downsides
of any such decision. In other words, what is the expected gain from
taking on this additional risk?
Conceivably, the outcomes would vary depending on the objectives of the
individual multi-asset fund and the risk appetite of the portfolio manager.
The paper also argues that whether fixed-income assets – be they
sovereign or credit (or both) – are currently overvalued is only half the
question. The flipside is that if they are overvalued, where else could
you deploy your capital? Are there alternative asset classes or sub-asset
classes that offer relatively better value?
Greater exposure
to credit provides
a greater expected
premium over cash
and therefore a
greater buffer against
rising rates.
If there are more attractively valued asset classes, what is the conviction
in this valuation and, more importantly, what is the range around that
expectation? If there is greater risk, does the expected return make it
worthwhile?
In relation to credit spreads and cash, it observes that:
›› All sections of the Australian bond market are expected to outperform
cash over one, three, five and 10-year horizons.
›› Greater exposure to credit provides a greater expected premium over
cash and therefore a greater buffer against rising rates.
›› The global fixed interest aggregate measure is expected to underperform
cash (A$) if yields rise more quickly than what is already priced into
the US market. Combine that with the decreasing hedging margin (the
margin between US and AUD cash rates) and the total returns no longer
look so attractive versus cash. This, in effect, is pricing the negative
outcome for global bonds.
It is important to note that many fixed-income managers (whether
by luck or design) target an above-benchmark yield to achieve a
higher return (all things being equal). This tilt to credit will provide
a greater cushion against rising rates and provide some insurance
against the market mispricing the level of yields in future years.
The paper says that to justify a move away from fixed income or
credit, one needs to decide whether any or all of the key reasons
for holding it in the first place no longer hold true. Conversely,
the current market rationale has to be so strong that a short-tomedium term tactical view is justifiable.
All the evidence points to any decision to go short duration (and
or credit) being a function of risk tolerance, conviction in market
views and potential upside. This is related to a fund’s objectives
and the scale of the upside relative to the risks and impact of
getting the call wrong.
For more information and a copy of this paper, contact:
Nicki Ashton, Head of Strategic Partnerships on (02) 9229 5521 or email [email protected]
Issued by Russell Investment Management Ltd ABN 53 068 338 974, AFS Licence 247185 (“RIM”). This document provides general information only and has not been prepared having regard
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