Having international exposure in your equity allocation has become the norm. Many Nasdaq companies are household names and Warren Buffett’s long-term tip of ‘buy and hold the S&P’ appeals to investors around the world.
The consensus view is that opportunities in international equity markets can be as attractive, if not more so, than those at home.
But when it comes to fixed income, the home bias remains strong. While there is comfort in the familiar, it also limits the opportunity set and can introduce unintended concentration risks.
When the composition of the UK fixed income universe is fully understood, expanding your geographic remit – even after hedging to sterling as we know investors do not want to run currency risk in their fixed income holdings – could prove less risky than staying close to home.
Gilts and beyond
After 12 years of ultra-low yields, income has returned, with segments of the market offering return opportunities akin to equities. Now seems an opportune time to review bond allocations in order to optimise risk-adjusted return potential.
Gilts are the stalwart of UK fixed income, and with yields of 4.3 per cent on the one-year and 3.7 per cent on the 10-year, they have regained their appeal as a core allocation.
For a higher target return, you might then look to UK investment grade, which trumps domestic sovereign debt with yields around 5.6 per cent. But buyer beware, a problem lurks under the surface.
The UK investment-grade market has an unusually strong concentration bias. Of the 940 bonds within it, 39 per cent of these are banking and real estate names. In today’s environment of elevated mortgage rates, this creates significant sector risk, pushing yields out.
To get the best of investment grade with the lowest level of risk, we believe broadening your geographic remit and taking an international view provides the optimal solution.
The US investment-grade market has a lower yield of 4.8 per cent (hedged) but less concentration risk than the UK, with banks comprising 19 per cent of the market and real estate just 3 per cent.
There are also opportunities in US investment-grade names in the growth sectors like technology and energy that are not available in the UK market.
Investment grade sector concentration risk
| GBP investment grade | US investment grade | EUR investment grade | |
| Banking | 26% | 19% | 27% |
| Real Estate | 13% | 3% | 6% |
| Total | 39% | 22% | 33% |
Largest investment grade sector concentrations
| GBP investment grade | US investment grade | EUR investment grade |
| Banking 26% | Banking 19% | Banking 27% |
| Utilities 16% | Financial Services 9% | Utilities 10% |
| Real Estate 13% | Healthcare 9% | Financial Services 7% |
Source: Mirabaud Asset Management, ICE BAML
UK high yield also contains notable concentration risk. The market is small, with 99 bonds offered by 66 issues. 26 per cent of these bonds sit in the retail sector, with supermarket names dominating.
Given CPI is proving sticky at 10 per cent and unemployment is forecast to tick up through 2023, the UK consumer is set to decline and this degree of retail concentration could negatively impact returns.
While high yield can be an interesting allocation for higher potential returns, we believe exposure needs to come from a better spread of sectors for an optimised risk/return profile.
The US and European markets are much larger and are without the elevated concentration risk that the UK has, yet yields are attractive at 8.7 per cent (hedged) and 8.1 per cent (hedged) respectively, versus 10 per cent for the UK.
