How Best to Navigate Today’s Markets?
In the current environment, we think investors in euro-area government bonds can expect stable but relatively low returns, while holders of euro high-yield corporate debt should earn higher returns but with much more volatility. In our view, investing in a dynamically managed portfolio that can allocate to both these markets represents the best of both worlds. That type of portfolio – managed dynamically and with a benchmark-agnostic approach – can provide a more attractive yield on a risk-adjusted basis than the market. Our research suggests it can offer a significantly higher yield than the traditional euro aggregate benchmark (i.e. a blend of high quality government and corporate bonds), with lower duration and similar volatility,* despite having a higher allocation to high yield. Compared with higher-yielding euro-area government bonds (e.g. Italian BTPs), a dynamic portfolio can offer better yield and lower concentration risk. And although its yield is lower relative to the euro-area high-yield market, the quality of the dynamic portfolio is much higher. This is an important differentiator in this part of the cycle when lower-rated and highly levered bonds are much riskier.
Why Not Opt for Higher Yields in the US?
The US market, with its higher yields, may appear more attractive, but the cost of hedging US dollars back into euros remains elevated at 3%, making the adjusted returns for euro investors less appealing. And with the US at a more advanced stage in the credit cycle, risks are mounting for higher-yielding US bonds.
The Bigger Picture
Of course, political risks are elevated across the euro area, but we believe the ECB has the determination and the tools to ward off major crises. Over the longer term, we appreciate that structural issues in Europe remain, and that the effectiveness of monetary policy will likely decrease over time. Over the short/medium term we are mindful of heightened headline risk and volatility (e.g. ahead of European elections). Against this background, we believe a dynamic and benchmark-agnostic approach has more attractions than ever—in particular, because it has the flexibility to take advantage of increased volatility.
*over the last 5 years to 31 December 2018 both the representative portfolio and the Bloomberg Barclays Aggregate Euro Bond Index have exhibited average volatility between three to four percent.
