Tilt Toward Government Bonds
As credit cycles wind down or geopolitical risks rise, a manager can rebalance investors’ portfolios by tilting toward higher-quality, interest-rate-sensitive securities at the expense of the riskiest sectors of the credit market. This makes a portfolio more liquid. Should credit markets sell off, investors can sell their outperforming US Treasuries and other highly liquid assets and rebalance toward higher-risk assets at more attractive prices.
To our mind, it makes sense today to tilt toward higher-quality securities. While we don’t expect a US recession, we are keeping an eye on the manufacturing slowdown and cooling world GDP growth. In addition, the US credit cycle is now in its eleventh year. That’s why, even though investors may be unhappy with low yields on government bonds, it would be a mistake to eliminate them.
It’s important to hold duration, or sensitivity to changes in interest-rate levels, when there’s significant uncertainty on the global geopolitical stage. During periods of market turbulence, government bonds’ duration serves as an offset to equity and credit market volatility, mitigating downside risk.
However, when the US Treasury yield curve is flatter than normal, as it is today, we think it makes sense to reduce holdings of long-duration bonds such as 20- and 30-year US Treasuries. These securities’ yield per unit of duration is low compared to the yield per unit of duration in the intermediate portion of the yield curve. Investors should therefore consider concentrating US Treasury exposure in bonds maturing in six to nine years.
Another reason to tilt portfolios toward rate-sensitive assets? Investors aren’t being properly paid to take credit risk. Most credit assets are expensive today. Take the US high-yield market, where the average extra yield (spread) over comparable government bonds averaged 3.4% on December 31, 2019. That’s well below the long-run average of 5.5% since January 1, 1994.
Be Selective
Of course, investors shouldn’t hold only government bonds. They should blend exposure to high-yield corporate bonds with positions in credits that offer an attractive mix of yield and quality, such as subordinated European bank debt and select investment-grade corporate and emerging-market debt.
Subordinated European bank debt was issued to comply with global Basel III regulations that required banks to build up equity capital buffers. Because they’re lower in the capital structure, subordinated bonds issued by investment-grade banks offer yields like those of speculative-grade securities.
In fact, yields on European additional Tier 1 (AT1) bonds, the securities that would take a hit first if the issuing bank ran into trouble, comfortably outstrip those on European and US high-yield bonds. European bank debt is particularly attractive because European financials are in a slightly earlier stage of the credit cycle than their US counterparts.
What other credits look attractive in the later stage of the credit cycle? Perhaps surprisingly, BBB corporate bonds, which offer yields like those in the high-yield market thanks to overblown fears about “fallen angels.” Many of these companies have prioritized debt reduction and still have healthy earnings.
Lastly, among traditional high-income-generating sectors, the dovish tilt by developed-market central banks is broadly supportive of emerging-market debt. The economic fundamentals of emerging-market countries have also markedly improved in recent years. We think these assets may get an added boost as monetary policy around the world gets even easier in 2020.
Think Outside the Box
But investors can do even more to reduce volatility sparked by geopolitical risk by adding securitized assets to their balanced strategies.
Why? Because US mortgage-backed securities are more resilient than high-yield credit to geopolitical risk.
Consider the higher-yielding assets on the return-seeking side of the mortgage strategy, such as commercial mortgage-backed securities (CMBS) and credit risk–transfer (CRT) securities—a kind of bundled residential mortgage debt issued by US government-sponsored enterprises Fannie Mae and Freddie Mac. As Display 2 shows, both CMBS and CRTs have weathered the ups and downs of the US-China trade war better than high-yield credit.
