The great rotation from bonds to equities
While recent extreme volatility in global bond markets again raises the question of the role of fixed income in investor portfolios, new analysis from AXA Investment Managers (AXA IM) shows the significant impact a “great rotation” from bonds to equities could have on investor portfolios.
In The Great Rotation paper AXA IM’s leading researchers discuss and analyse investors’ capacity to take on additional risk and the potential for significant asset allocation shifts in the current market environment.
A great rotation is a big shift of strategic long term asset allocation driven by a combination of factors, including: long-term risk budgeting, the regulatory environment, monetary policy and liquidity. In 2013, AXA IM analysis shows these factors have seen a shift from cash to equities, rather than bonds to equities as investors risk appetite returns and they seek higher returning investments.
However, AXA IM’s Director of Australia & New Zealand, Craig Hurt, said any ‘great rotation’ of investor portfolios from bonds to equities could have multiple repercussions on investment decision making.
“For such a move to occur, both market and regulatory conditions would have to support greater appetite for risk. We evaluated the concept of a great rotation with regards to investors’ long-term investment objectives. The impact of a great rotation in global markets on the average Australian could be significant if their asset allocation is not given due attention,” he said.
“Similarly, if there is indeed a great rotation out of bonds and into equities at the same time Australian retirees are moving out of equities and into bonds in the search for a reliable income stream, then retirees may find themselves on the wrong end of a big global trade,” Mr Hurt added.
Focus on the fixed income landscape
According to AXA IM, while bond investors may already have come to terms with the risk that their exposure to high rated government and investment grade bonds will deliver negative real returns over the medium term, there are still a number of options for fixed income investors in an environment of asset class rotation including; reducing portfolio duration, adding inflation protection and yield pick-up.
“Investors can minimise interest rate risk by limiting the duration of their portfolios or by further replacing interest rate risk for credit risk. There is also a strong argument for seeking inflation protection,” Mr Hurt said.
AXA IM believes there are a number of important questions investors should ask to understand the risk of significant asset allocation shifts from bonds to equities.
Firstly, will other assets offer greater certainty of higher returns if bond yields are to remain very low? Secondly, are we on the verge of a bond bear market that will generate a period of negative returns in fixed income? Third, if that is the case, will it be through higher interest rates or a re-pricing of credit risk premiums? Lastly what can bond investors do in an environment of asset class rotation?
Such questions are even more important for an ageing Australian population as they move from the accumulation to decumulation phase.
“Whereas in the accumulation phase there is a focus on real-return growth assets, the investment strategy in the post-retirement world is generally centred on capital protection, inflation protection and yield generation,” Mr Hurt concluded. .
AXA IM’s Great Rotation paper provides an in depth analysis of options available to investors across the various asset classes.