Going beyond cash or single instruments
While short-term cash deposit accounts have done well over the past few years, we think they now come with a significant reinvestment risk, given declining rates. Unlike bonds, cash instruments do not benefit from the uptick in bond valuations that typically accompanies rate cuts, and income resets at lower levels, suggesting diversification into fixed income may be overdue. Many investors have already switched part of their cash holdings to domestic government bonds — with several governments now actively targeting retail investors — or other “safe-haven” instruments. However, in our view, further steps could now be warranted. While there is an important role for domestic government bonds in portfolios, complementing single-country exposure with a diversified high-quality global bond portfolio could:
- mitigate reinvestment risk and help shield portfolios from excessive volatility;
- diversify the significant beta risk embedded into a single-country issuer, which may become pronounced in today’s uncertain environment; and
- offer the potential for capturing higher yields that may be available elsewhere.
Adopting a flexible fixed-income approach
Targeted diversification does not necessarily mean having to take on significant duration or credit risk. In fact, we think that in an uncertain environment, flexibility can be a bond investor’s best friend. Specifically, we think high-quality, unconstrained approaches offer an attractive avenue to complement existing portfolios as they have limited average duration and credit exposure while offering diversification across the full gamut of, countries, sectors and themes.
And we think the signs are encouraging for flexible fixed-income strategies to continue their positive trajectory in today’s diverging world, offering both significant scope for downside protection and opportunities for upside potential amid market dislocations. These sudden readjustments are likely to be a constant feature of this new economic era.
For instance, at this stage, the US administration’s policy programme is likely to lead to structurally higher inflation, heightened volatility and a potential reversal in global capital flows, as well as a slide in the US dollar. Elsewhere, Japan and the UK appear to be pursuing monetary policies that are still in dissonance with the economic data, while the euro area remains hobbled by political constraints in France, concerns about debt sustainability — only partially offset by Germany’s fiscal measures — and the continued impact of the war in Ukraine. Across the board, US tariffs and the risk of a surge in Chinese imports to non-US markets are now key areas of concern for policymakers and investors.
On the opportunity side, countries like Australia, New Zealand and Canada boast low levels of public debt but high private debt, meaning their central banks may be better equipped to deal with any financial instability and more sensitive to a deterioration in the cycle. They could deliver higher and more stable total returns given high starting points in yields as well as acting as alternative “safe havens”.
Bottom line
We believe investments in fixed income should seek to achieve three key objectives:
- reliable and recurring income, with a growth component
- enhanced diversification and liquidity
- capital preservation over the longer term
In today’s more unpredictable environment, we think these objectives can be best achieved by adopting a more flexible approach that targets a global opportunity set within robust risk constraints. In our view, having greater flexibility on duration, country and sector selection can help protect both income and capital during periods of heightened volatility. As such, we think this can be a powerful addition to most portfolios, helping to smooth the impact of volatility on single country or region allocations by diversifying exposures across diverging economic and policy cycles.
In practice, there are a wide range of unconstrained strategies available in the market and investors will need to ensure that the chosen approach meets their specific requirements. Given the uncertain environment, one avenue investors may wish to pursue is allocating to flexible fixed-income strategies that place a higher emphasis on capital preservation and liquidity through higher allocations to select high-quality government bonds — but still provide the potential for positive long-term returns through exposure to a rich, global opportunity set.
