Navigating yield in order to build a truly diversified portfolio is a challenge for many bond investors, which is where an adviser may come in.
But why exactly should advisers be so concerned with ensuring their clients have a diversified portfolio of fixed income assets?
There are numerous benefits that come with having a diversified portfolio, regardless of the asset class.
Investors may more commonly associate diversification with equities, making sure their portfolio is invested across regions, sectors and market capitalisation, for example. However, a similar approach also applies to bonds.
In fixed income being diversified across regions and types of credit can help spread the level of risk the client is exposed to and help achieve the desired return.
Martin Horne, head of European high yield investments at Barings, acknowledges: “Diversification of a credit portfolio is a good idea, in our opinion, regardless of the economic environment.
“A diverse portfolio, for example, can help counteract unforeseen corporate or industrial underperformance, such as the relatively recent commodity cycle market movements.”
He continues: “In the context of strong earnings and low default environments, we still believe that fixed income represents good relative value against most risk asset classes.”
Risk and return
Mr Horne reasons if economic growth continues, spread tightening will provide capital appreciation potential to a bond portfolio.
On the other hand, if economic conditions deteriorate, the low interest rate environment will likely be extended and spreads may widen to offer greater return potential.
Nicolas Trindade, senior portfolio manager at AXA Investment Managers, suggests optimal diversification “is about striking the right balance between risk and return”.
“You want to benefit from low volatility and drawdowns but also get the best yield achievable, which means you may have to compromise on yield to target attractive risk-adjusted returns,” he says.
Investors have been starved of yield for some time – another reason for diversifying away from a single source of yield in portfolios.
David Stubbs, global market strategist at JPMorgan Asset Management, points out many investors have been searching for yield beyond the bonds issued by their domestic governments.
“Correlations between government bonds remain high, meaning that investors can step out of their domestic market into higher yielding ones, such as New Zealand and Australia, with only a small chance that those markets will perform differently from their own,” he says.
“The next step is to consider fixed income sectors with radically different drivers from government bonds. Those include the parts of the fixed income universe which perform well when the economic picture is strong.
“They include corporate bonds, particularly high yield, and also bonds issued by the governments and companies of emerging markets.”
Getting the right combination
But Mr Stubbs reiterates: “As with most things in investing, all these fixed income sectors work best when combined with one another. Choosing the right amount to place in each type of fixed income, let alone the exact exposures within those sectors, is a challenging task.”
