The role of multi-asset credit in DC plans

Diversification

A multi-asset credit approach may offer sources of return that vary considerably from year to year. Notable return contributions over time can reflect a team’s breadth of collaboration with their sector specialist investment teams, with some notable sector activity including:

• European contingent convertibles (CoCos) — Through collaboration between credit and equity bank analysts, CoCos exposure provided a strong return source from 2014 to 2019.
• Emerging market high-yield corporates — Initially an opportunistic allocation initiated in 2017, additional attractiveness in the sector has led to many MAC managers expanding this exposure.
• Convertible bonds — First built around a unique market opportunity in spring 2020, there has been additional interest in the sector over time.
• Structured finance — Many teams have recently been increasing allocations to mezzanine RMBS and CMBS securities, fostering close collaboration between credit analysts and equity domain experts (e.g., in homebuilders, REITS) to identify issuances that were excessively discounted relative to the riskiness of their underlying collateral.

We believe income generation could become even more important to maintaining a resilient return profile in the future. With global central banks withdrawing support for financial markets and becoming less coordinated in their actions, we expect that spread volatility could be structurally higher than has been the case since the global financial crisis.

Moreover, there is minimal overlap between the major allocations in a multi-asset credit strategy and the sectors represented in the Bloomberg US Aggregate Index (many core bond approaches). Accordingly, rolling annualized correlations of monthly returns for this index and many multi-asset credit approaches have traditionally been meaningfully low. This diversification benefit was particularly pronounced in periods such as February and March 2020, when core fixed income provided downside protection as higher-yielding sectors sold off, and more recently in June 2023, when multi-asset credit approaches generated positive total returns while duration-sensitive core fixed income experienced negative total returns.

Real-time allocations to sector opportunities

A MAC allocation can provide nimble asset reallocation and more integrated risk oversight across higher-yielding credit sectors, with an investment team able to move swiftly to take advantage of dislocations throughout the fixed income universe. These dislocations are often only apparent to specialist investors who are deeply immersed within those sectors. For example, at Wellington, the team closely collaborates with a broad platform of specialist investors who can advise on arising dislocations and help to implement advantaged exposures quickly should be well positioned to deliver on a MAC allocation’s return objectives.

As an illustrative example, Figure 2 displays the potential benefits associated with a multi-sector approach relative to those of single sectors. Multi-asset credit approaches have historically displayed attractive risk/return characteristics relative to standalone sector peers.

Figure 2

Stable income profile

Especially with yields having reset higher in recent years, higher-yielding fixed income sectors offer the potential for attractive income generation, which is often underrepresented, especially in the DC plan allocations of participants approaching retirement. A multi-asset credit approach’s ability to position around a wide range of sector, and security-level, market inefficiencies may help generate not only more resilient returns, but also more reliable income.

As Figure 3 shows, the yield to worst, by sector, of both a mock MAC policy benchmark, as well as some of the key sectors leveraged by such an approach. With yields having reset higher in recent years, we think higher-yielding credit sectors could have even greater potential for income going forward.

Figure 3

A complement to core fixed income

In summary, augmenting core or core-plus fixed income with a multi-asset credit allocation has in our view, three major benefits. A low correlation of returns with core fixed income provides meaningful diversification and can lead to a more stable total return experience, especially in turbulent market environments. Allocating in real time across higher-yielding sectors provides more opportunity for enhanced returns than allocating to these sectors individually. Finally, this approach generally has a higher yield from these diverse sources, which can provide a stable income stream and further dampen volatility. With these potential benefits, we believe the case for a multi-asset credit approach alongside core fixed income warrants discussion. 

Investment risks: Multi-Sector Credit

Principal risks

Asset/mortgage-backed securities risk – Mortgage-related and asset-backed securities are subject to prepayment risk, which is the possibility that the principal of the loans underlying the securities may prepay differently than anticipated at purchase. Because of prepayment risk, the duration of mortgage-related and asset-backed securities may be difficult to predict.

Bank loan risk – Bank loans involve risks, including the risk of nonpayment of principal and interest by the borrower. In the event of a default, bank loans contain the risk that any loan collateral may be impaired and that the investor may obtain less than the full value for the collateral sold. An investment in bank loans may also be in the form of an assignment or a participation of all or a portion of a loan from a third party. Participation may involve counterparty exposure to the original bank.

Commingled fund risk – Investments in funds or other pooled vehicles will generally indirectly incur a portion of that fund’s operating expenses and/or fees and will inherit a proportion of the fund’s investment risks. Funds may have different liquidity profiles based on their dealing terms, and the types of instruments in the fund. In the event a fund holds illiquid instruments, it is possible that a full redemption from the fund could result in taking custody of illiquid instruments that could not be sold in the market.

Credit derivatives risk – Credit derivatives transfer price, spread and/or default risks from one party to another and are subject to additional risks including liquidity, loss of value, and counterparty risk. Payments under credit derivatives are generally triggered by credit events such as bankruptcy, default, restructuring, failure to pay, or acceleration. The market for credit derivatives may be illiquid, and there are considerable risks that it may be difficult to either buy or sell the instruments as needed or at reasonable prices. The value and risks of a credit derivative instrument depend largely on the underlying credit asset. These risks may include price, spread, default, and counterparty risk.

Credit risk – The value of a fixed income security may decline due to an increased risk that the issuer or guarantor of that security may fail to pay interest or principal when due, as a result of adverse changes to the issuer’s or guarantor’s financial status and/or business. In general, lower-rated securities carry a greater degree of credit risk than higher-rated securities.

Currency risk – Active investments in currencies are subject to the risk that the value of a particular currency will change in relation to one or more other currencies. Active currency risk may be taken on an absolute, or a benchmark-relative basis. Currency markets can be volatile, and may fluctuate over short periods of time.

Derivatives risk – Derivatives can be volatile and involve various degrees of risk. The value of derivative instruments may be affected by changes in overall market movements, the business or financial condition of specific companies, index volatility, changes in interest rates, or factors affecting a particular industry or region. Derivative instruments may provide more market exposure than the money paid or deposited when the transaction is entered into. As a result, a relatively small adverse market movement can not only result in the loss of the entire investment, but may also expose a portfolio to the possibility of a loss exceeding the original amount invested. Derivatives may also be imperfectly correlated with the underlying securities or indices they represent, and may be subject to additional liquidity and counterparty risk. Examples include futures, options and swaps.

Emerging markets risk – Investments in emerging and frontier countries may present risks such as changes in currency exchange rates; less liquid markets and less available information; less government supervision of exchanges, brokers, and issuers; increased social, economic, and political uncertainty; and greater price volatility. These risks are likely to be greater relative to developed markets.

Fixed income securities risk – Fixed income security market values are subject to many factors, including economic conditions, government regulations, market sentiment, and local and international political events. In addition, the market value of fixed income securities will fluctuate in response to changes in interest rates, and the creditworthiness of the issuer.

Interest rate risk – Generally, the value of fixed income securities will change inversely with changes in interest rates, all else equal. The risk that changes in active interest rates will adversely affect fixed income investments will be greater for longer-term fixed income securities than for shorter-term fixed income securities.

Leverage risk – Use of leverage increases portfolio exposure and may result in a higher degree of risk, including (i) greater volatility, (ii) greater losses from investments than would otherwise have been the case had leverage not been used to make the investments, (iii) margin calls that may force premature liquidations of investment positions.

LIBOR risk – Now that certain IBORs (including USD LIBOR) are no longer deemed representative, securities that contain fallback language will transition to an alternative reference rate, depending on the deal documents. Some securities lack any fallback language or contain fallback language that differs from current industry standards and the rate could remain permanently fixed. As a result, the liquidity and value of these securities may be adversely impacted and clients may be forced to hold these securities to maturity.

Liquidity risk – Investments with low liquidity may experience market value volatility because they are thinly traded (such as small-cap and private equity or private placement bonds). Since there is no guarantee that these securities could be sold at fair value, sales may occur at a discount. In the event of a full liquidation, these securities may need to be held after liquidation date.

Non-investment-grade risk – Lower-rated securities have a greater risk of default in payments of interest and/or principal than the risk of default for investment-grade securities. The secondary market for lower-rated securities is typically less liquid than the market for investment-grade securities, frequently with more volatile prices and larger spreads between bid and ask price in trading.

Additional risks

Concentration risk – Concentration risk is the risk of amplified losses that may occur from having a large percentage of your investments in a particular security, issuer, industry, or country. The investments may move in the same direction in reaction to the conditions of the industries, sectors, countries, and regions of investment, and a single security or issuer could have a significant impact on the portfolio’s risk and returns.

Contingent convertible securities risk – Contingent convertible securities (CoCos) are fixed income securities that, under certain circumstances, either convert into common stock of the issuer or undergo a principal write-down by a predetermined percentage if the issuer’s capital ratio falls below a predetermined trigger level. Due to contingent write-down, write-off, and conversion features of contingent capital and contingent convertible securities, such high-yielding instruments may have substantially greater risk than other forms of securities in times of credit stress. This action could result in a partial or complete loss even if the issuer remains in existence. In full principal write-downs of CoCos, for instance, bondholders could theoretically lose the value of their investment completely, even though the common equity of the bank retains (and perhaps eventually recovers) some value.

Convertible securities risk – Convertible securities are hybrid securities that combine the investment characteristics of bonds and common stocks, and may be exchanged or converted into a predetermined number of the issuer’s underlying shares, the shares of another company, or shares that are indexed to an unmanaged market index at the option of the holder during a specified time period. Although to a lesser extent than with fixed income securities generally, the market value of convertible securities tends to decline as interest rates rise. Because of the conversion feature, the market value of convertible securities also tends to vary with fluctuations in the market value of the underlying shares and thus is subject to equity market risk as well.

Model risk – Model risk occurs when systematic and/or quantitative investment models used in investment decision making fail. These models may evolve over time and have risks related to mistakes in software or data inputs that could go undetected for a period of time before being rectified. Models may fail to adequately measure or predict market risks or outcomes and could result in a loss of value or opportunity cost.

Options risk – An option on a security (or index) is a derivative contract that gives the holder of the option, in return for the payment of a “premium,” the right, but not the obligation, to buy from (in the case of a call option) or sell to (in the case of a put option) the writer of the option the security underlying the option (or the cash value of the index) at a specified exercise price prior to the expiration date of the option. Purchasing an option involves the risk that the underlying instrument will not change price in the manner expected, so that the investor loses the premium paid. However, the seller of an option takes on the potentially greater risk of the actual price movement in the underlying instrument, which could result in a potentially unlimited loss rather than only the loss of the premium payment received. Over-the-counter options also involve counterparty risk.

Preferred stock risk – Preferred stock represents an equity or ownership interest in an issuer. If an issuer is liquidated or declares bankruptcy, the claims of owners of bonds take precedence over the claims of those who own preferred stock. Preferred stock is subject to many of the risks to which common stock and debt securities are subject, and may be subject to more volatility because it may trade with less frequency and in more limited volume. Additional risks include interest rate sensitivity, deferred distribution payments, involuntary redemptions, and limited voting rights.

Repo & reverse repo risk – Both repurchase and reverse repurchase transactions involve counterparty risk. A reverse repurchase transaction also involves the risk that the market value of the securities the investor is obligated to repurchase may decline below the repurchase price.

Important disclosures: Multi-Sector Credit

Additional performance information

PAST PERFORMANCE DOES NOT PREDICT FUTURE RETURNS. There can be no assurance nor should it be assumed that future investment performance of any strategy will conform to any performance examples set forth in this material or that the portfolio’s underlying investments will be able to avoid losses. The investment results and any portfolio compositions set forth in this material are provided for illustrative purposes only and may not be indicative of the future investment results or future portfolio composition. The composition, size of, and risks associated with an investment in the strategy may differ substantially from the examples set forth in this material. An investment can lose value.

Impact of fees
Illustration of impact of fees: If USD 100,000 was invested and experienced a 10% annual return compounded monthly for 10 years, its ending value, without giving effect to the deduction of advisory fees, would be USD 270,704 with an annualized compounded return of 10.47%. If an advisory fee of 0.95% of average net assets per year were deducted monthly for the 10-year period, the annualized compounded return would be 9.43% and the ending USD value would be USD 246,355. Information regarding the firm’s advisory fees is available upon request.

Selection of representative account
The current representative account became effective on 1 March 2014 because it was the least restrictive account at the time of selection. For data shown prior to the current representative account effective date, data of the representative account(s) deemed appropriate for the time period was used. Further information regarding former representative accounts can be provided upon request. Each client account is individually managed; individual holdings will vary for each account, and there is no guarantee that a particular account will have the same characteristics as described. Actual results may vary for each client due to specific client guidelines, holdings, and other factors. In limited circumstances, the designated representative account may have changed over time, for reasons including, but not limited to, account termination, imposition of significant investment restrictions, or material asset size fluctuations.

Access products
If access products are held by the portfolio they may not be included in the calculation of characteristic data. Access products are instruments used to gain access to equity markets not otherwise available and may include (but are not limited to) instruments such as warrants, total return swaps, p-notes, or zero strike options.

Additional disclosures
Securities indices are unmanaged and are not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly into an index.

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