Global Asset Tracker: Low yield world sparks new roles for debt and alternatives

After a four decade-long bull market, bonds are unlikely to feature in client portfolios for the performance they generate any time soon. 

Asked to pick the asset class expected to perform best over the next 10 years, the panel of 50 private banks which took part in PWM’s fifth annual Global Asset Tracker survey ranked fixed income bottom (Fig 1). But then, while the ultra-low rate environment has pushed investors towards more risky parts of the bond universe, the role of fixed income has not traditionally been to generate returns. 

Fixed income should act as an anchor allocation and shock absorber to protect portfolios in case of market downturn, according to more than 80 per cent of our panel. Seventy per cent think bonds are a diversifier for equity risk, despite increasing correlation between equities and bonds. Forty per cent believe they should feature to preserve capital (Fig 2).

Yet, private banks’ strategic allocation to fixed income, at 40 per cent in a balanced portfolio, is the lowest it has been since the launch of PWM’s GAT survey in 2016 (Fig 3). Just under 70 per cent have a tactical underweight position to the asset class (see Fig 5 page 20). Moreover, around 45 per cent expect asset allocation to fixed income to further decrease this year (Fig 7). Almost 90 per cent see the persistence of the low yield environment as the biggest challenge. Interestingly, over the next decade, the normalisation of monetary policy and the risk of errors, namely a too rapid hike of interest rates, top the list of the biggest threats to the asset class.

Emerging market debt, both hard and local currency, is believed to offer the most attractive return opportunities in the fixed income space, and EM debt is the asset class to which the highest number of banks (almost 70 per cent) have an overweight exposure (Figs 4 and 5). 

“Emerging market debt continues to be our main overweight in fixed income,”says Willem Sels, global chief market strategist at HSBC Private Banking. “We believe a number of EM central banks will cut interest rates, many countries have improved external balances, and global economic growth has likely bottomed. These factors should be good for risk appetite.” 

Yet, the safe-haven characteristics of this asset class are still appreciated, despite trillions of dollars of  negative yeilding government and corporate debt. The bulk of fixed income assets in private banks’ strategic asset allocation is held in developed government and investment grade bonds (Fig 6), although these are the segments to which the highest proportion of private banks have underweight positions.

“High yield credit and emerging market debt offer a reasonable yield pickup considering the low probability of recession. But risk-on assets can move negatively with staggering speed, this is why we maintain sizeable allocations to safe-haven government bonds and gold,” says Kleinwort Hambros’ CIO Mouhammed Choukeir. 

The entire fixed income space is “extremely challenging, very expensive and very unappealing,” adds Fahad Kamal, chief market strategist at Kleinwort Hambros. The UK bank maintains a risk-on asset allocation biased towards equities, which have more attractive valuations than “anything in fixed income”.

Over the past few years, our panel of private banks have been highly sceptical of the ability of bonds to generate returns, especially when compared to equities. Yet in 2019,  continued monetary stimulus by central banks, led by the Fed, drove both equities and fixed income markets to high levels. 

“Our view of fixed income has been poor, even last year, and we had a fabulous year. Even government bonds produced 5-6 per cent returns, and high yield double digit returns,” says Mr Kamal. But in such a low yield environment, is still possible to make money by investing in fixed income? 

Even from these low levels, there is potential to generate returns, he explains. Yields can always go lower, into negative territory, as have German and Japanese government bonds. Also, buying pressure from institutional, liability-driven investors means a large market for government bonds will continue to exist. 

Moreover, monetary intervention is always a possibility, if the economy starts deteriorating. 

“Many times in the last 40 years, people have predicted the end of the boom market, it hasn’t happened and it is the longest asset bubble in public markets right now,” adds Mr Kamal. While unlikely to happen this year, “extremely rich” bond valuations must be taken into account when predicting future returns.

Equity diversifier

Worries about whether fixed income can still be an effective diversifier for equity has driven private banks to increase exposure to other assets expected to shield portfolios against a rise in volatility. 

While US Treasuries are still effective in US dollar portfolios, gold, real estate and currency exposure - Japanese yen versus the US dollar, and the Swiss franc versus the euro – give protection to European investors, says Stéphane Monier, CIO at Banque Lombard Odier. 

Real assets have replaced some fixed income allocations in portfolios, he adds, with gold replacing European and Swiss government bonds, in both euro and Swiss franc portfolios. 

More than 50 per cent of private banks have an overweight allocation to alternatives, and gold is increasingly appealing. “We see falling rates and higher central bank purchases as being supportive of the gold price,” says Bill Street, group CIO at Quintet, formerly KBL epb. 

“As yields go down in bonds, there is less of an opportunity cost of holding gold, and ETFs provide a liquid, very effective way of gaining exposure to this commodity,” he adds. Assets other than fixed income are being utilised to satisfy investors’ need for yield. Good quality, high-yielding dividend stocks in the public space should be considered as bond proxies in today’s low yield environment, says Mr Street. 

This theme was highlighted by several banks, with 50 per cent believing dividend-paying equities offer the most attractive opportunity in the equity space (see Fig 4 here). There are about 1000 high-yielding dividend stocks that are returning approximately three or four times as much as their own government bonds, reports Mr Street.

Alternatives are also useful diversifiers. For clients willing to “harvest the illiquidity premium” and have more private exposure, the private market is going to generate 7 to 10 per cent premium per annum, over the public equity and debt market, estimates Quintet. “I believe that alternatives as an asset class will become far more mainstream in 2020 and beyond,” adds Mr Street, also recommending global macro and market neutral funds. 

Fifty-five per cent of respondents believe clients’ allocation to private equity is going to increase this year (Fig 7), with private equity also topping the ranking in terms of expected returns within alternatives, followed by infrastructure and commodities (see Fig 6 here).

Northern Trust continues to have “high confidence” in high yield bonds given its base case that the global economy will continue to grow, and defaults will remain low, explains Katherine Ellis Nixon, CIO. Interest rate sensitive assets, such as infrastructure and real estate, also feature as one of the bank’s high conviction calls in client portfolios, given the bank’s rate outlook and investors’ “continued search for yield”.

Infrastructure exposure

To complement allocations to fixed income, Danish bank Nykredit introduced infrastructure investments in client portfolios five years ago, because of its long-term, relatively stable return with a high cash yield component, explains Peter Kjærgaard, head of Nykredit Wealth Management. 

The bank launched a funds of funds solution, expected to generate 6 to 8 per cent going forward, which combines an alternative portfolio, investing in illiquid, long-term infrastructure projects, with a more liquid, short-term allocation to government bonds and Danish triple A mortgage bonds. 

Sustainability plays a big role in the strategy. “The great thing about the infrastructure type of investments is the cash element. For example, we are heavily invested in offshore wind parks, and as soon as they start operating, they produce an income, which makes an otherwise illiquid asset class more liquid to the benefit of client portfolios,” explains Mr Kjærgaard.

Opportunities in infrastructure spending are also highlighted by several private banks such as BNP Paribas. Some developed countries are close to their limits in terms of monetary easing, and will embrace expansionary fiscal policy, which is expected to be more effective in stimulating growth and raising inflation expectations. 

Moreover, some governments are stepping up spending to address environmental goals, which tie in with infrastructure spending. Fifty-four per cent of our panelists believe global coordinated fiscal policy will start supporting economic growth this year.

However, although the correlation between fixed income and equities was stronger in 2018 and 2019, high quality credit is still an effective diversifier against equity risk, particularly deflationary threats, believes Niladri Mukherjee, head of portfolio strategy, chief investment office, at Bank of America. 

Client portfolios hold Treasuries, as well as municipal bonds, although the bank has an underweight to fixed income and overweight to equities. “The US is still the high yield capital of the world, and even though our 10-year Treasuries yield 1.6 per cent, it’s way higher than any other developed market sovereign bond yield.”  

Building better portfolios

One way to improve the quality of fixed income portfolio is to look for “sustainable” alternatives to traditional bonds, according to UBS. 

The green bond index (GREN) has achieved a similar total return to the ICE global corporate credit index since March 2014. Yet, it has less exposure to cyclical sectors and a higher average credit quality than the broader investment grade market, which should be useful against an uncertain market backdrop. Multilateral development bank bonds have “steadily outperformed” US Treasuries since January 2018, with a low volatility of excess returns. 

Multilateral developed bank debt replaced Treasuries or other government bonds in UBS’s multi-asset fully sustainable client portfolios, which the bank launched three years ago. 

“In many cases multi-lateral development bank debt has a yield pick up, and in some cases, like the World Bank debt, it is safer than US Treasuries because it is backed by multiple governments,” explains Mark Haefele, global CIO, at UBS GWM.

Bonds could make inroads in ‘smart’ or rules-based ETFs, says Kleinwort Hambros’ CIO Mouhammed Choukeir. These ETFs use macro or style factors to help improve portfolio construction and investment selection. For instance, factors can help screen for bonds that have a lower likelihood of default or those that appear underpriced. 

“Chances are bond markets will see disruption from the passives, but more from the rules-based, smart beta type,” he believes. But more integrated platforms on a global exchange will need to address the liquidity issues that have prevented a stronger growth of passive bond funds so far.