Wellington: Multi-asset credit: Evergreen anchor in an age of volatility and divergence

By Raina Dunkelberger, CFA, CAIA, Investment Director, Wellington Management

Fixed income, traditionally regarded as a relative safe haven compared to equities, has long been a standard component of a well-balanced portfolio. Today, the market environment looks very different compared to history, and investors are questioning whether fixed income continues to play this role well in a higher-volatility world with greater policy divergence.

In our view, the short answer is yes. This said, the better question isn’t whether or not to allocate to fixed income, but rather: What kind of fixed income approach makes sense in today’s investment landscape?

Why ask this question now?

A standard approach to fixed income is something in line with the Bloomberg US Aggregate Index, a proxy for the US bond market. High-quality investment-grade (IG) corporates and US agency mortgage-backed securities (MBS) comprise a significant portion of this index — areas of the market that may be challenged in the coming years because:

• Credit spreads are at historically tight levels, meaning extra yield for a given bond has decreased, while the associated risks remain the same and interest-rate risk is the dominant driver of returns
• US Treasury notes remain volatile due to macro uncertainty, shifting Fed policy, and heavy supply

So, what are fixed income investors to do? We believe complementing traditional fixed income investments with a global, diversified, higher-yield credit allocation could be the answer.

Facing fears of default in higher-yielding credit…

A multi-asset credit (MAC) approach spanning several areas of fixed income has the potential to generate higher returns than a traditional approach relying more heavily on US IG credit and US agency MBS, even when you adjust for volatility (Figure 1).

Figure 1

The typical reason investors may hesitate to embrace a MAC approach is because they fear the volatility associated with relatively riskier areas of the fixed income market, including defaults. While fear of defaults in lower-quality fixed income is understandable, in our view, we’re past the peak default cycle. Consumers and businesses have entered this period of policy change and uncertainty from a position of strength, which is likely to help them withstand further market turbulence or a global economic slowdown. This is a big difference compared to the global financial crisis (GFC), for example, when the economic slowdown spelled a full-blown default cycle because consumers and businesses were overleveraged and thus unable to weather the uncertainty.

…and embracing opportunities

The potential benefits of a MAC approach to the fixed income market are many. Chief among them is the diversification potential. The Bloomberg US Aggregate Index is primarily comprised of US Treasury bonds, US IG corporates, and US agency MBS. Given the current environment, it may not be prudent to keep all of one’s investment eggs in such a narrow basket, even if it’s worked in the past. A new economic era may call for a new, more diversified way of operating.

Exposure to a broader swath of the fixed income market may also be prudent given rising sector and regional dispersion. Global economic cycles aren’t marching in the familiar, comfortable lockstep we saw in the relatively cushy years following the GFC. Add to this the fact that there are an unprecedented number of active geopolitical conflicts going on across the globe, which may amplify these dispersion dynamics. The diversification inherent in MAC strategies could offset the risks of these dynamics by extending more broadly, perhaps, than many US-centric strategies, or those with limited access to higher-yielding credit markets.

Actively managed MAC investing not only seeks to mitigate risks through diversification, but also to pursue return opportunities across the full range of global credit sectors. The ability to rotate among sectors has the potential to maximize risk-adjusted returns over cycles. Active managers in this space can exploit disruption in credit markets, enhancing forward-looking, total-return potential. Managers with deep reserves of experience and ample global research capabilities may be especially well equipped for such situations.

The bottom line is we’re living in a very different world today than even a few years ago, and, as the world changes, fixed income investors may need to evolve their approach to account for new risks and opportunities.

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