Many investors are piling cash in bank accounts because they argue that income opportunities are limited or do not exist all together. Some others continue buying in the same assets in which they have invested in the past, with little consideration being given to the inherent risks.
The past few years were not easy for bond investors as yields across sovereign and high-quality bonds fell. This was thanks to central banks’ low interest rate policy and bond-buying programmes. The situation may not change anytime soon, and with higher default risk, it is wise for bond investors to rethink their bond exposures.
Over the last decade, many investors dived in lower-quality corporate credit and emerging markets. Both asset classes have historically generated high income and more volatile returns. Back in March the situation was no different.
The riskiest parts of the bond market led the way down with double digit declines.
While low income returns may warrant a higher allocation to riskier bonds, does this shift have to come at the expense of capital preservation at all cost? I strongly believe that the answer is no.
Many investors are obsessed with generating mid-to-high single digit interest. While income options with such returns do exist, these come with higher volatility and default risks.
Investors can overcome this high-income bias and the subsequent higher risks by assessing the actual income they would require from their portfolio of financial assets in addition to their other sources of income, such as pension and rental incomes.
In today’s market environment, holding a diversified portfolio of assets is more important than ever. Various sectors and industries will exist in a different shape in a post-COVID world. Some will emerge stronger while others will struggle to keep up with a changing environment – faster than most of us have ever thought. With less clarity about the future and following the reaction in the high-yield bond and emerging markets, should investors rethink their fixed income exposures?
Institutional investors have long argued in favour of a more flexible approach to bond investing. Traditionally, bond investors either invested in a portfolio of directly-held bonds or in bond funds with specific strategies with exposure to one type of bonds, say, investment grade or high-yield bonds.
On the opposite side, a typical flexible bond portfolio approach provides investors with a portfolio of bonds invested in different types of fixed income assets, namely global sovereign bonds, investment grade bonds, high-yield bonds, emerging market bonds and local bonds. Each different asset class has a different role to play. The less risky portion of these portfolios aims to protect the value of the portfolio against volatile periods while the credit elements aim to generate income.
In my view, a flexible and active approach to fixed income investing is the way forward for investors to generate ongoing interest income with lower risk of default.
A flexible approach to a bond portfolio has the potential to provide investors with a more diversified bond strategy which is less exposed to one single sub-asset class. More importantly, an active bond portfolio will provide investors with less volatile returns.
In addition, a flexible and active approach should be able to withstand volatile periods much better than a portfolio of high-yield bonds or emerging market bonds as the exposure to the latter asset classes is expected to be less.
As stated earlier, investors should not just look at the interest rate their portfolio of bonds or income funds are generating. This cannot be stressed enough when investors do not withstand or are not comfortable with the volatility experienced lately in the highest-yielding bonds. An assessment of the actual income a client requires is paramount and, more importantly, in a situation where investors have enough income that does not require them taking excessive risks.
High-quality bonds are yielding next to nothing, and we should expect this to remain as long as consumer confidence and demand for goods and services remain under pressure. On the other hand, some interesting opportunities are emerging as the bond market shifts from a sellers’ to a buyers’ market.
We have come across some attractive yields compared to what we got used to in the past few years. An income fund with a flexible and global approach has the discretion to invest in areas where there is potential for resilient income and avoid sectors or industries which will struggle under a ‘new normal’.
These type of strategies should give investors more peace of mind about fixed income investing as their portfolio can generate stable levels of income while avoiding sectors that the manager does not like, while also reducing home bias.
Which portfolio or mix of flexible income portfolios suits investors’ needs depend on a number of factors and it is very important that investors understand clearly the goals and risk profile of the strategy they are investing in. The first important consideration is whether the risk profile of the portfolio matches that of the investor. Finally, if investors understand the risk profile of the fund and the type of assets the portfolio will invest in, they should keep in mind that the investment is there for the long term. Then a regular portfolio review is a must to make sure that the portfolio’s objectives and the risk profile are still aligned with those of the investor.
This article was prepared by Gabriel Mansueto, head of investment advisers at Jesmond Mizzi Financial Advisors Ltd. The 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 more information, contact Jesmond Mizzi Financial Advisors Ltd of 67, Level 3, South Street, Valletta, on 2122 4410, or e-mail gabriel.mansueto@jesmondmizzi.com.