Are yields changing the face of fixed income funds?
The not so diversified fixed income funds universe
By Cristian Balteo, Senior Product Specialist for Nordea Asset Management
Traditionally, the role of diversified fixed income funds within investors’ portfolios has been dual. While on one side, investors want to get reasonable levels of yield from them, diversified fixed income funds are also expected to deliver a certain level of protection when risky assets and – more specifically – equities struggle.
These diversified fixed income funds have the flexibility to invest across a very broad universe of fixed income sub-asset classes, such as government bonds, mortgage backed securities (MBS) and investment grade (IG) corporate bonds with an overall high credit rating level. Moreover, they also have the ability to tap into other higher yielding universes such as and high yield (HY) corporate bonds and emerging markets (EM) bonds, even if this type of assets is traditionally more risky/volatile and hence requires a different treatment from a portfolio construction perspective.
Over the past few years, as yields have dropped to the current historically low levels and investors have continued to chase returns almost at all cost, the more conservative sub-asset classes have been pushed to a much less prominent role in most diversified fixed income funds. Meanwhile, the more attractive HY corporate bonds and EM bonds – that can be wrapped around the HY credit assets denomination – have dominated the asset allocation of these products.
Thanks to liquidity being pumped into markets by very supportive monetary authorities, risky assets have been enjoying from an almost continuous bull market since the end of the great financial crisis of 2008. This environment has been fertile ground for many portfolio managers who by simply tilting their portfolios towards HY credit assets have been able to deliver very attractive returns – from an absolute and risk adjusted basis.
Nevertheless, if we deconstruct the factors behind most of this positive performance, the underlying reality becomes very clear. HY credit assets have a naturally higher correlation with the economic cycle, as is the case for equities. Hence, they tend to perform very much in line with equities, especially when volatility spikes and investors dump risky assets in their search for safe heavens. The implication of this is that while most diversified fixed income portfolio funds are – as their name states – purely investing into fixed income assets, their behaviour increasingly resembles that of equities.
This presents at least two important issues that investors should seriously consider: First, the diversification inside these funds is now considerably lower, as they have dropped traditionally defensive assets, such as high quality government bonds, given their low expected returns, and have mostly concentrated on piling up HY credit assets that are highly correlated among each other. Second, the diversification these funds have historically brought to investors’ overall portfolios has also been considerably reduced, as HY credit and like types of assets are highly correlated to equities – the other big component of almost all investors’ portfolios.
At Nordea, we have a different approach when constructing diversified fixed income portfolios. For more than a decade now, Nordea’s Multi Assets Team has been building portfolios following what we call our “Risk Balancing philosophy”. Our approach aims to find the most attractive return drivers across two families of risk premia: those that are highly correlated to equities and those that are negatively correlated to equities. The idea is to make sure we build portfolios that – irrespective of the name-tag in the asset classes used – are structurally balanced between the two types of premia in order to be able to deliver on a pre-set outcome across the investment cycle without necessarily having to depend on making the right top-down macro call.
While this is a posture that might not have been very popular during the recent bull market years, investors would do well to ponder how prepared their portfolios are if equities – and equity-like HY credit assets – were to suffer a correction from their currently stretched valuation levels.