In this era of ultra-low interest rates, we have seen core fixed income allocations in many client portfolios drop noticeably, in some cases by one-third to one-half what investors would normally consider prudent.
While it is true that private bank chief investment officers (CIOs) and independent financial advisors aren’t paid to guarantee clients certain losses on negatively yielding government bonds, it remains critical for strategic asset allocators to hold core fixed income. Here are four reasons why.
Core fixed income can play an important role in managing distributions. Distributions are not free; they require protection against a poor sequence of returns.
Each distribution is like a negative return on the portfolio that must be counterbalanced by an equivalent positive gain. This makes a recovery from price declines potentially very difficult.
Since core fixed income assets historically rise in a bear equity market, a CIO is able to redirect distributions from those assets temporarily without further impairing the capital of the risk assets in drawdown.
Using distributions to rebalance this way in times of crisis is one of the most important strategies to increase the longevity of distribution portfolios.
Portfolio Longevity Analysis
To model the combined principle erosion of losses and distributions on a portfolio, we need a different approach than we apply to standard accumulation portfolios. One of the best tools we have is the Monte Carlo simulation, which looks at the probability of the portfolio’s success or failure over good, bad, and moderate future market conditions. In this way, we can get a view of not just the average likely outcome, but how our portfolio might withstand extreme outcomes.
As an example of the importance of core fixed income, we compare a moderate 50 per cent equity/50 per cent fixed income portfolio, and a more aggressive 80/20 “moderate” portfolio that has moved to more equity because of fixed income fears—a situation we have often encountered.
In 42 per cent of all simulated market environments, the more aggressive moderate portfolio fails to distribute an inflation-adjusted 4 per cent distribution for 30 years. The rate of failure on the original 50/50 moderate portfolio is half. Put another way, at the twenty-third percentile of possible markets (a poor market outcome) the 50/50 moderate portfolio is able to distribute for 30 years, whereas the more aggressive moderate portfolio runs out of money six years earlier on average.
Source: Bloomberg, GSAM
Core fixed income can help prevent potentially damaging investment decisions. The discipline of behavioural finance as applied to mutual fund flows has shown that investors have often missed out on the full return potential of many asset classes. They frequently buy risky assets too high, and sell them too low.
The term “investor return” has been used to describe this phenomenon. The resulting “investor return gap” describes a kind of penalty the average investor bears by entering and exiting at the wrong times compared to a long-term, professional investor.
Core fixed income assets are generally lower in volatility than equities or other risky assets. By diversifying with core fixed income, an IFA is likely to smooth the client experience in her portfolio, thereby reducing the risk that her clients’ behaviour leads to detrimental timing decisions.
“Dry powder” matters. For the investment adviser whose mandate includes the ability to make tactical shifts, we believe there is a very real value to having “dry powder,” meaning cash or core fixed income that gains when risk assets have just fallen, presenting an attractive buying opportunity at an attractive price.
This opportunistic ability can be a primary source of multi-asset manager alpha. In a more challenging market for equities, we believe managers with a high ability to add alpha can gain more from buying assets on sale than they will pay in foregone returns from holding core fixed income over the next cycle.
Liquidity matters. It will be true of most CIOs that the institution or end clients for which he looks after money has outside assets and income that he does not directly oversee. It is critical for the best interests of the client that these are accounted for.
For example, in times of market stress, many clients may see lower outside business incomes, receive smaller bonuses at work, pull in less rental yield on privately owned real estate, or experience any number of hardships which necessitate accessing the portfolio run by the CIO at the least opportune time.
Similarly, many university endowments and charitable foundations discovered during the financial crisis that declining charitable giving required that they provide a larger-than-normal percentage of their institution’s operating budget.
For this reason it is critically important that CIOs account for potential “impingements” by keeping an appropriate level of liquidity, in the form of cash and core fixed income investments.
We have seen too many portfolios labelled “cautious” even though half or more of future portfolio risk will be driven by high-yielding, “risk-on” investments.
High yield bonds, convertible bonds, and real estate are not core fixed income substitutes. Short-duration high yield corporates, BBB-rated sovereign debt, and floating rate bank loans all hold very real risk of being impaired and unable to fulfil the functions mentioned above at the very moment of greatest need.
True flight-to-safety fixed income is high in quality. Because of the current environment, we prefer shorter duration fixed income assets.
One example of where we believe quality has been underestimated by the market is US student loans backed by the US government. They feature a US government guarantee of at least 97 per cent, but tend to have wider spreads and higher carry than other asset-backed securities. Finally, cash can still play an important role in an investor’s ability to manage through the realities clients face.
In light of recent high equity valuations, we advocate taking the time now to review the distribution requirements, time horizon, risk tolerance, and outside contingencies of your clients, to make sure that the level of cash and core fixed income within your portfolio matches those needs appropriately.
Brendan McCurdy is executive director, portfolio strategy EMEA, strategic advisory solutions at Goldman Sachs Asset Management. The views expressed above are his own and should not be taken as investment advice.