In its most recent commentary following Global Chief Investment Strategist Russ Koesterich’s visit to Australia last week, the BlackRock Investment Institute cautions investors to consider “hidden risks” in today’s fixed income portfolios in its paper titled “Forget Rotation: Think Risk Mitigation,”.
Below is a summary of the report:
- For some market observers today, a so-called “Great Rotation” — a massive shift of assets out of bond portfolios and into equities – is just over the horizon. But the Black Rock Investment Institute (BII) believes that the scenario has “major holes”—and instead is urging investors to take steps now to mitigate the inherent risks still lurking in many fixed income portfolios.
- “With muted and regionally disparate economic growth, the foundation for a sustained risk rally looks shaky,” the BII notes in a new commentary, “Forget Rotation: Think Risk Mitigation.” What is certain, the BII believes, is that bond portfolios carry fewer diversification benefits and more risk than in the past – and more risk than many investors believe.
- “Rather than worry about the bursting of a bond bubble and/or salivate over a massive shift to equities, investors would do well to focus on these hidden risks,” the BII says.
Safety Cushions No Longer
- Fixed income portfolios have become progressively riskier, the BII notes, with the hunt for yield in an historically low yield environment compressing spreads on many credit instruments to record lows. “Ultra low yields mean safety cushions – to what extent a bond’s income offsets a price fall due to a rise in yield — have turned into beds of nails,” the BII says. A mere 17 basis point uptick in the 10-year US Treasury yield, for example, would wipe out a year’s worth of income.
- At the same time, the argument for a coming “Great Rotation” back into equities is flawed, the BII believes. A resumption of robust global growth that would justify a strong move back into stocks is by no means certain.
- Also, though the Great Rotation scenario assumes that strong inflows into bond funds since early 2009 came from stocks – and will now return there — in fact these flows more likely came from money market funds.
The bottom line for investors, the BII notes: The interest rate risk in fixed income remains acute, and portfolio mitigation measures are in order.
What Does This Mean For Investors?
- The BII suggests that investors consider the following steps to manage potential fixed income risk:
Uncover Risks: Recognize hidden risks in bond portfolios and consider diverging from fixed income benchmarks—or even abandoning them. - Go Short: Shorten duration and emphasize higher yielding credit over “safe” government bonds.
Change Gears: Markets tend to overshoot. Be ready to take advantage by rotating duration, credit sectors or asset classes. - Focus on Income: Do not count on capital gains in bond sectors that have had a great run such as US municipal bonds. Buy them for income.
- Quality Bargains: The hunt for yield has boosted not-so-great income assets. Climb up the quality ladder for a small loss in yield.
- Buy Insurance: Volatility in most assets is very low, so options to protect against downside risks or participate in upside opportunities are cheap.
- (Bond) Pickers Welcome: Correlations between asset classes are breaking down. This puts a premium on security selection.
- Neutral Bliss: Reduce market exposure by buying favored assets and simultaneously selling short similar but less desirable securities.