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Asset allocation

Optimizing outcomes through alternatives:
Fixed income

David R. Wilson
Head of Global Fixed Income Client Portfolio Management
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Fixed income

The nontraditional, or “plus,” sectors of fixed income — preferred securities, emerging markets debt, high yield corporates and leveraged loans — present attractive yields for investors seeking enhanced income. 

Opportunities in these sectors are continually shifting, emphasizing the need to take a diversified and dynamic investment approach. Given the high levels of idiosyncratic risk in each of these sectors, active management is synonymous with risk management here. We examine several nuances of the return drivers in these sectors that investors should consider.

Considerations for risk factor-based investing

Plus fixed income delivers valuable flexibility 
Publicly traded fixed income can play multiple roles in an institutional portfolio, including cash flow generation, inflation hedging and equity diversification. The enhanced yield of plus fixed income segments adds to this flexibility, particularly for pension plans, endowments and foundations. By generating enough current income to meet near-term liabilities, plus fixed income can immunize the front-end of the plan’s liabilities and extend the investor’s time horizon. This allows investors to take on more illiquidity risk in other portions of the portfolio.

1Q20 yield-to-worst by fixed income sector 

Redefining volatility through an asset-liability lens 
When investing in plus fixed income, as well as private credit, the volatility of these asset classes takes on a much different meaning when viewed in the asset-liability space. For asset-only investors (i.e., those who focus on portfolio returns in isolation of liabilities), the mark-to-market volatility of plus fixed income or private credit may make these assets too volatile for the portfolio. But in the asset-liability space, portfolios of emerging markets debt, preferred securities, high yield debt and leveraged loans can be laddered to match up with liabilities, making the mark-to-market volatility largely irrelevant.

Preferred securities are largely overlooked by institutional investors 
Institutional investors — particularly pension plans, endowments and foundations — are underemploying preferred securities, which can serve as a valuable tool in generating attractive yields at appropriate risk levels. Many investors have bad memories of how preferreds performed in the Global Financial Crisis, but the landscape has changed dramatically since then. The majority of preferreds are issued by U.S. banks, highly regulated issuers that came into 2020 in their strongest-ever capital position. Thus, the asset class is supported by solid fundamentals and attractive technical factors. Even though these securities are subordinated, they are an important source of long-term capital for issuers.

U.S. banks historical tangible common equity ratio 

Emerging markets provide many opportunities for skilled investors
Emerging markets debt is a complex asset class that has matured significantly in the past decade; the majority of emerging markets debt is now investment grade. Emerging markets debt is a composition of dozens of different markets, each with its own idiosyncratic risks, so active management in the asset class is paramount. In addition to vast differences in the economic and political risks driving returns in each country, emerging markets debt provides institutional investors the ability to navigate between sovereign debt, corporate credit, local currency and U.S. dollar-denominated bonds.

High yield and leveraged loans present challenges and opportunities 
Default rates, which are always front and center in these markets, may rise to levels seen during the Global Financial Crisis as a result of the coronavirus pandemic as well as the concurrent energy crisis. These headwinds make individual credit selection more important than ever. Investors should focus on opportunities that not only provide healthy yield but also can withstand a challenging environment, such as companies with very strong cash flow or those that operate in more defensive industries.

COVID-19 Impact: Diverging paths to recovery in emerging markets

Our belief that emerging markets debt should not be thought of as a monolithic asset class has never been more applicable than it is today. We expect significant dispersion in performance, as the paths to recovery across emerging markets will be subject to their own policy response and circumstances.

Given the maturation and diversity of the asset class, this crisis provides attractive and unique opportunities for investors that can identify countries with sound policy frameworks and reasonably large fiscal and monetary buffers; the same can be said for companies with strong balance sheet and liquidity positions. Of course, investors must be able to stomach near-term volatility.

Crisis-driven investment activity has caused valuations and implied probabilities to become disconnected from underlying fundamentals. Current market pricing implies very high default rates that historically have not materialized in emerging markets. While drawdowns in the sector can be significant, recoveries have historically been strong. To the extent debt forgiveness and multilateral funding are made available, sovereigns may weather the crisis while remaining current on debt, benefiting long-term investors.

Government and corporate repayment capacity will be weakened as fiscal receipts and corporate earnings decrease while liabilities remain. Willingness to pay is also likely to be reduced as governments prioritize domestic healthcare spending to mitigate the impact of COVID-19 while the distressed level of bond prices may make restructurings more acceptable.
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Profille image of Dimitrios Stathopoulos
Dimitri Stathopoulos
United States

All market and economic data from Bloomberg, FactSet and Morningstar. 

The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. 

Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible. 

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, or liability for, decisions based on such information, and it should not be relied on as such. 

A word on risk 

All investments carry a certain degree of risk, and there is no assurance that an investment will provide positive performance over any period of time. Equity investing involves risk. Investments are also subject to political, currency and regulatory risks. These risks may be magnified in emerging markets. Diversification is a technique to help reduce risk. There is no guarantee that diversification will protect against a loss of income. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. In portfolios that include lower-rated municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Credit ratings are subject to change. AAA, AA, A, and BBB are investment grade ratings; BB, B, CCC/CC/C and D are below-investment grade ratings. As an asset class, real assets are less developed, more illiquid, and less transparent compared to traditional asset classes. Investments will be subject to risks generally associated with the ownership of real estate-related assets and foreign investing, including changes in economic conditions, currency values, environmental risks, the cost of and ability to obtain insurance, and risks related to leasing of properties. Socially Responsible Investments are subject to Social Criteria Risk, namely the risk that because social criteria exclude securities of certain issuers for nonfinancial reasons, investors may forgo some market opportunities available to those that don’t use these criteria. Investors should be aware that alternative investments including private equity and private debt are speculative, subject to substantial risks including the risks associated with limited liquidity, the use of leverage, short sales and concentrated investments and may involve complex tax structures and investment strategies. Alternative investments may be illiquid, there may be no liquid secondary market or ready purchasers for such securities, they may not be required to provide periodic pricing or valuation information to investors, there may be delays in distributing tax information to investors, they are not subject to the same regulatory requirements as other types of pooled investment vehicles, and they may be subject to high fees and expenses, which will reduce profits. Alternative investments are not suitable for all investors and should not constitute an entire investment program. Investors may lose all or substantially all of the capital invested. The historical returns achieved by alternative asset vehicles is not a prediction of future performance or a guarantee of future results, and there can be no assurance that comparable returns will be achieved by any strategy. 

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