Multi-asset portfolios, true to their name, are designed to achieve specific outcomes for clients- whether that’s generating total returns or securing stable income streams. This entails investing across various asset classes, spanning equities, bonds, cash, and alternatives. The essence of a diversified multi-asset strategy lies in capitalising on distinct asset behaviours in response to changing market dynamics, a key element of which is understanding asset correlations.
Diversification, achieved by allocating investments across asset classes with different risk return profiles and correlation patterns, serves as a vital risk management tool. Low or negative correlations among assets enable risk mitigation during market stress, while favourable correlations harness the potential of thriving markets. This approach aligns with the core purpose of multi-asset investing – delivering attractive returns or income with prudent risk management, making it a resilient strategy adaptable to evolving market landscapes.
In the art of constructing successful investment portfolios, achieving balance among various asset classes is paramount. Fixed income, represented by bonds, plays a pivotal role in maintaining this equilibrium. Fixed income strategically counters potential volatility from assets like equities or commodities when integrated into multi-asset portfolios.
This strategy aims to cultivate diversified portfolios that optimise returns while managing risk, providing investors with resilient investment solutions. Investment managers strategically employ fixed income as a ballast in their portfolios. This is due to the fixed income behaviour in market sentiment shift or turbulence.
One of the core principles in bond investing is the inverse relationship between market interest rates and bond prices. When interest rates in the market go up, the prices of fixed-rate bonds typically go down. Conversely, when market interest rates decrease, bond prices generally rise. This concept is vital to grasp because it makes investors susceptible to a phenomenon known as interest rate risk, which means the value of your investment can change due to shifts in interest rates
Understanding Fixed Income Credit Quality
Here’s how fixed income credit quality and coupon rates are interconnected:
Credit Ratings:
Credit rating agencies like Moody’s, Standard & Poor’s (S&P), and Fitch assign credit ratings to bonds and issuers based on their assessment of credit risk. These ratings provide an indication of the credit quality of the issuer and the associated default risk.
High Credit Quality:
Bonds issued by financially stable entities with a low risk of default receive higher credit ratings (e.g., AAA, AA, A). These bonds are considered “investment-grade,” and they typically offer lower coupon rates because investors are willing to accept lower returns in exchange for safety.
Lower Credit Quality: Bonds issued by entities with higher default risk receive lower credit ratings (e.g., BBB, BB, B, C). These bonds are considered “speculative” or “junk” bonds and typically offer higher coupon rates to attract investors due to the increased risk.
Source: Digit, August 2023 Risk-Return Tradeoff: The coupon rate on a bond is determined by a variety of factors, with credit quality being a significant one. In general, higher credit quality bonds have lower coupon rates because they are less risky investments. Conversely, lower credit quality bonds offer higher coupon rates to compensate investors for taking on greater risk.
Investor Preferences: Investors have different risk tolerance levels and investment objectives. Some investors, such as pension funds or conservative investors, may prefer higher credit quality bonds with lower coupon rates for the stability and reliability of income. Others, like speculative investors or those seeking higher returns, may be willing to invest in lower credit quality bonds with higher coupon rates.
Market Conditions:
Economic conditions and market sentiment can also influence the relationship between credit quality and coupon rates. During periods of economic uncertainty or financial market stress, investors may demand higher coupon rates for bonds with lower credit quality, further reinforcing the link between credit quality and coupon rates.
In summary, fixed income credit quality reflects the creditworthiness of the issuer and affects the coupon rates offered on bonds. Higher credit quality bonds generally have lower coupon rates, while lower credit quality bonds typically offer higher coupon rates to compensate investors for the increased risk of default. Investors must assess their risk tolerance and investment objectives when considering bonds with varying credit qualities and coupon rates.
Unlocking Investment Potential: Bond Sensitivity, Duration, and Convexity
In the realm of fixed-income investments, grasping the dynamics of duration and convexity is like having a trusty compass for your financial journey. Duration and convexity are invaluable tools in any bond investor's toolkit, helping them decipher the intricate dance between bonds and interest rates. By grasping the sensitivity of bonds to rate changes, investors can unearth opportunities to construct portfolios that are robust and adaptable, ready to thrive in the ever-evolving financial landscape.
Understanding Duration:
Duration risk is how sensitive a bond or a collection of bonds is to changes in interest rates. It takes into account factors like the bond's yield, coupon rate, and maturity. Short duration bonds typically reside at the shorter maturity end of the yield curve and are influenced by changes in monetary policy. Conversely, long duration bonds are positioned at the longer end of the curve and are typically affected by market expectations of the future economic environment.
In the bond market, longer-dated bonds often command a liquidity premium. However, when the market begins to offer less yield for longer duration bonds and more yield for shorter-duration bonds (short maturity), it can convey valuable information. This shift in yield patterns can serve as a signal, offering insights into changing market sentiment and expectations regarding interest rates and economic conditions.
Exploring Convexity:
Consider convexity as the hidden gem within bonds. It unveils the curvature in the relationship between a bond's price and interest rates. While duration provides a linear perspective, convexity unveils the non-linear facets of bond behaviour. This non-linearity is where astute investors can uncover unique opportunities.
Convexity adds an intriguing layer to this opportunity. As rates climb, the non-linear nature of convexity can work in Favour of investors. Bonds with positive convexity may experience milder price drops than linear duration calculations might suggest. This can lead to attractive risk-reward scenarios, drawing in investors in search of resilience amid changing interest rates.
The impact of interest rate shifts on bond prices and total returns, is determined by duration and convexity. Higher duration implies a greater sensitivity to changes in yield, which, in turn, depends on both monetary policy and market expectations. This understanding equips investors to strategically navigate the bond landscape. They may opt for shorter-duration bonds, which exhibit lower sensitivity to rate hikes, effectively shielding against potential losses. Price Impact of change in Yield (UK Bonds)
Source: Alpha Beta Partners, As at 24 August 2023 Price Impact of change in Yield (Global bonds)
Source: Alpha Beta Partners, As at 24 August 2023
Strategic Bond Duration: Navigating Short, Ultra Short, and Long-Term Bonds
Use of Short Duration: Benefits & Pitfalls
In the vast landscape of investment options, short duration stocks, also known as short-term bonds, occupy a unique and valuable niche. Short duration stocks offer a valuable tool in the investment toolbox, providing stability, liquidity, and risk mitigation. However, they also come with trade-offs, including lower yield potential and limited capital appreciation.
To make informed investment decisions, Investment manager carefully weighs the benefits and pitfalls of short duration stocks against their specific financial objectives and risk tolerance. These financial Instruments offer a spectrum of advantages and potential drawbacks that savvy investors and managers must carefully consider.
• Interest Rate Resilience: Short duration stocks have shorter maturities, making them less affected by interest rate fluctuations. In rising rate environments, they experience smaller price declines, preserving capital. Additionally, they provide steady income and are less exposed to credit risk.
• Liquidity and Risk Mitigation: Near maturity bonds are highly liquid, offering flexibility to adapt to changing market conditions swiftly. This liquidity makes them suitable for seizing opportunities or addressing immediate cash needs. Moreover, their reduced exposure to credit risk and issuer defaults enhances their appeal to risk-averse investors.
• Lower Yield Potential and Limited Capital Appreciation: Short duration stocks typically offer lower yields compared to longer-term bonds. This can be a drawback for investors seeking higher income or substantial capital gains. Additionally, they may not experience the same level of capital appreciation as longer-duration bonds when interest rates fall.
• Reinvestment Risk and Opportunity Cost: When short-term bonds mature, investors face reinvestment risk. If interest rates have fallen since the initial investment, reinvesting at lower yields can reduce overall portfolio returns. Focusing solely on short duration stocks may also result in missing out on potential gains from longer-term investments during certain market conditions.
Use of Ultra-Short Duration: Benefits & Pitfalls
Ultra short duration funds have gained prominence as an indispensable asset class, offering unique advantages that can bolster the resilience and performance of multi-asset portfolios.
By carefully assessing the benefits and challenges associated with these funds, investment
managers can construct well-rounded portfolios that align with their specific financial goals and risk tolerance.
• Capitalising on Market Fluctuations: Short duration stocks allow investors to exploit short term price movements. By identifying trends and patterns in the market, traders can buy low and sell high, Maximising profit potential within a compressed timeframe.
• Risk Management: Short-term investing can be a prudent way to manage risk. It limits
exposure to market volatility and unforeseen economic events, as investors can quickly exit
positions if conditions deteriorate.
• Increased Trading Costs: Frequent trading, a hallmark of short duration investing, can lead to higher transaction costs in terms of commissions and bid-ask spreads. Investors must carefully consider these expenses when formulating their strategies.
• Market Timing: Successfully navigating short duration stocks often requires precise market timing. Mistimed entries and exits can lead to losses, making it crucial for investors to stay informed and adaptable.
• Tax Implications: Short-term capital gains are typically taxed at a higher rate than long term gains. Investors should be aware of the potential tax consequences of short duration strategies and plan accordingly.
Use of Long Duration: Benefits & Pitfalls Long duration stocks can serve as valuable components within multi-asset portfolios, especially for those looking to maximise income potential and diversify their investments. While they offer the allure of higher yields and stability, investors should remain mindful of their sensitivity to interest rate changes and issuer-related risks. Long duration stocks often characterised by their extended investment horizon, present investors with both opportunities and considerations that require careful evaluation. • Maximising Income Potential: Long duration stocks, similar to long-term bonds, provide the opportunity to earn a higher interest rate or dividend yield. This attractive yield is a result of the issuer’s willingness to pay more in return for the certainty of locking in a known rate for an extended period. For investors seeking to maximise income in their portfolios, long duration stocks can be a compelling choice. • Diversification and Stability: The inclusion of long duration stocks in a multi-asset portfolio
can enhance diversification by introducing assets with different risk-return profiles. These
stocks often represent well-established companies with a history of stable performance,
offering stability and balance to the overall portfolio.
• Interest Rate Sensitivity: Long duration stocks share a characteristic with long-term bonds
in that they are sensitive to interest rate changes. If interest rates rise, the value of long duration stocks may decline, impacting the portfolio’s overall performance. Investors must be prepared for potential fluctuations in the value of these assets.
• Issuer Risk: Depending on the issuer, long duration stocks can carry a greater risk of default, particularly if the same issuer has other outstanding bonds or stocks that mature before the ones you own. It’s crucial for investors to conduct thorough research on the issuer’s financial stability and creditworthiness. Longer duration benefits from interest rate cuts
Source: Vanguard, As at 31 January 2023 UK long vs. short duration performance
Source: Bloomberg, Data from 1 December 1999 to 1 June 2023
Strategic Navigation of Fixed Income Durations: Adapting to the Investment Cycle
In the world of investment management, the art of balancing fixed income weightings across various durations is both a strategic and tactical endeavor.
An investment manager’s decision to move fixed income weightings across different durations throughout the economic cycle is a nuanced strategy driven by a blend of market dynamics, risk management, and investment objectives. It’s a constant balancing act between capturing yield and preserving capital, all while adapting to changing economic conditions to serve the best interests of their investors.
Economic Expansion Phase:
In the early stages of an economic expansion, investment managers prioritise shorter-duration fixed income securities like Treasury bills, commercial paper, and money market funds. Short-term securities offer crucial liquidity and flexibility, enabling rapid cash deployment for emerging opportunities.
They also carry lower interest rate risk, making them safer during central bank rate cuts to stimulate growth. Additionally, these assets are favoured for their lower credit risk exposure and higher safety levels, emphasising capital preservation.
Mid-Cycle and Transition Phases:
During mid-cycle phases of the economic cycle, investment managers adjust by extending their fixed income portfolios tactically. This involves allocating to intermediate-term bonds like Treasury notes and investment-grade corporate bonds.
This strategy targets higher yields and capital appreciation as interest rates stabilise. Longer-dated securities in this shift often provide greater yields, potentially enhancing income and diversifying the portfolio, spreading risk for improved returns.
Late-Cycle and Pre-Recession Phases:
In late-cycle and pre-recession phases, investment managers exercise caution. They mitigate risk by reducing exposure to longer-duration bonds to avoid potential capital losses from falling prices and anticipate rising pre-recession interest rates.
As a defensive measure, they allocate more to short-term instruments like money market funds and short-dated bonds, providing safety during turbulent economic times. Shorter duration securities are favoured for their reduced exposure to market volatility, emphasising the preservation of principal.
Recession and Post-Recession Phases:
In recession and post-recession phases, investment managers prefer shorter duration assets for stability and liquidity, including cash equivalents and short-term fixed income securities. They also watch for opportunities, seeking attractive long-term bonds at discounted prices as low interest rates can make yields enticing, potentially capturing long-term value.
Long Vs. Short Duration Performance in different years
Total return analysis of long-duration UK government bonds
Source: Vanguard, As at 31 July 2022 Total return analysis of long and short-duration UK government bonds
Source: Vanguard, As at 31 July 2022 IMPORTANT NOTICE:
This is a marketing communication from Alpha Beta Partners a trading name of AB Investment Solutions Limited. Registered in England at Northgate House, Upper Borough Walls, Bath BA1 1RG. AB Investment Solutions Limited is authorised and regulated by the Financial Conduct Authority. Reference No. 705062. This material is directed only to Financial Advisers in the UK and is not an offer or invitation to buy or sell securities. Opinions expressed, whether in general or both on the performance of individual securities and in a wider context, represent the views of Alpha Beta Partners at the time of preparation. They are subject to change and should not be interpreted as investment advice.
You should remember that the value of investments and the income derived there from may fall as well as rise and your clients may not get back the amount that they have invested. Past performance is not a guide to future returns.