Rebooting the risk curve

For most high net-worth individuals “wealth preservation” has long been the name of the game. Fixed income has been the cornerstone of that, for two reasons. It is lower-risk than most other asset classes and it provides income that can be siphoned off and used for daily living, without a sale of assets that would chip away at the rock of wealth which current or previous generations have accumulated.

Today however, the same imperative of wealth preservation is forcing private clients to think again about the fixed income part of their portfolios. With central banks’ policy rates set to rise over the coming years across developed markets, the yields of sovereign bonds and investment-grade companies are poised to do the same – reducing the value of bonds in portfolios.

Even if central banks’ interest rates do not rise, the bonds on this safe side of the fixed income market are still unappealing, with yields so low that investment managers are struggling to provide real-term returns.

“Clients want to protect their capital in real terms over the long run,” says Florent Brones, chief investment officer at BNP Paribas Wealth Management in Paris. “There is no other solution to this other than taking more risk or accepting that returns will be lower than inflation.”

However, if clients are willing to take more risk, he adds, there are “appropriate solutions” which can be found to preserve capital. “If they do not accept this, it becomes a much more difficult issue to deal with.”

Twin track approach

Private bankers broadly agree that this effort to attain higher returns through greater risk requires a twin-track approach. This involves both reducing overall fixed income allocations in favour of other asset classes that offer higher potential gains, and taking on more risk within fixed income in order to increase yields.

Within fixed income, private banks advocate travelling up the risk curve by investing in developed-market high-yield and dollar-denominated emerging market bonds, as well as both primary and secondary loan markets.

Outside this, popular strategies to substitute for fixed income are high-dividend stocks, property and hedge fund strategies. However, experts warn clients should be actively aware of the higher risks involved, rather than blithely assuming a high return can be earned with only a small amount of risk.

“The last time I heard about replacing fixed income with hedge funds it ended in tears, because funds of hedge funds mismanaged the expectations of clients, who believed hedge funds would never lose any money,” says Nicolas Campiche, Geneva-based CEO of  Pictet Alternative Investments, recalling the 2008 financial crash. “Hedge funds can be used to diversify away from fixed income, but they are not a proxy for fixed income.”

BNP Paribas Wealth Management is diversifying away from fixed income to an unusual degree, by historical standards. Its recommended position in the asset class is at the lowest, relative to the long-term benchmark, for many years: at 34 per cent for a mid-risk portfolio, it is 11 percentage points below the benchmark of 45 per cent.

“If clients share our view that they need to take on more risk, the first thing to do is to invest more in equities,” says Mr Brones, who points out that his wealth management division has a record overweight position in stocks. However, it is not necessarily easy to persuade clients to follow this. They are, he says, wary of equities following past stockmarket falls – which have left the FTSEurofirst 300 index 17 per cent down from its 2007 peak and 21 per cent down from its 2007 high. As a result, private clients tend to be underweight equities, relative to the bank’s recommendations.

Within equities, BNP Paribas advocates what it calls “secure dividend” stocks, taken from a list of companies which pay relatively high dividends but maintain low payout ratios.

It also likes private equity, because of low correlation with other asset classes. Within the remaining fixed income allocation, the French bank favours moving up the risk curve to gain higher yield, and then holding bonds until maturity. It advocates doing this through, for example, subordinated bank bonds and bank cocos – bonds whose value is contingent on particular events.

Aversion to equities could actually increase risk rather than reducing it, believes Mr Brones, noting that the US high-yield market, the biggest junk bond market in the world, is “probably more risky than the stocks of good-quality companies paying relatively high dividends”.

BNY Mellon Wealth Management is also greatly underweight in fixed income: its 20 to 23 per cent recommended range for mid-risk clients is the lowest in the 20 years that John Flahive, director of fixed income in Boston, has seen. This compares with a neutral allocation of 40 percent for bonds.

“Many of our clients have enjoyed really healthy returns on fixed income over several decades, but for the last several years we’ve been warning clients that the good years are, for the most part, probably behind us,” he says. “Clients need to look outside traditional core fixed income.”

BNY Mellon is, like BNP Paribas, keen on high-dividend stocks. Although it favours high-yield bond investment in an effort to produce a decent return, Mr Flahive notes yields have been driven down over the past few years, to around 5 per cent for high-yield bonds in the US market.

More exotic strategies favoured by the American firm in a bid to increase yields include European direct lending and distressed debt, and absolute return strategies involving buying one bond and selling another. Direct lending has grown in Europe to fill the gap left by cutbacks in lending by banks as they try to meet onerous capital requirements.

BNY Mellon is accessing this direct lending and distressed debt through a multi-asset fund recently launched by Alcentra, a high-yield investment management firm and subsidiary of the Bank of New York Mellon Corporation.

The bank also has a large allocation to “core municipal bonds” – investment-grade US municipal bonds – because they provide diversification and their income is tax-exempt.

Preventing over-exposure

UBS Wealth Management also likes multi-asset strategies, since they enable clients to reduce fixed income holdings while setting a limit to clients’ exposure to the higher-risk equity market. It has increased its investment in the risk parity strategies of hedge funds such as Bridgewater. UBS has been underweight fixed income on a tactical basis – a time horizon of the next six months or so – since January 2013.

Within fixed income, the bank subscribes to the consensus that it is essential to travel up the risk curve, to those parts of the market less sensitive to changes in central banks’ interest rates.

“We have reduced our investments in fixed income that are sensitive to yield increases, such as government bonds,” says Mads Pedersen, co-head of asset allocation at UBS Wealth Management in Zurich. “But we expect credit spreads to tighten and high-yield bonds to do very well.”

He cites continuing economic growth, which should improve corporate cashflow and keep high-yield defaults low. The bank predicts that the spread between high-yield and risk-free government bonds – currently about 2.5 percentage points, if one compares US Treasuries with US double-B bonds – will tighten by 0.5 percentage points over the next six months.

The notion that the upturn in developed market economies opens some doors in fixed income even while it closes others is shared by London & Capital (L&C), the London-based wealth manager. “Rises in interest rates are negative for government bonds, but not for the whole bond market,” says Sanjay Joshi, head of fixed income. “Fixed income is an asset class for all seasons. If you’re bullish on the economy and think rates will go up, buy high yield. If you think interest rates will go down, focus on investment-grade corporates.”

Credit spreads tend to tighten during times of economic growth, because the underlying companies issuing high-yield bonds benefit from better business conditions. The price of investment-grade corporate bonds tends to hold up better during times of economic weakness and accompanying low interest rates, as investors flee to safety.

In line with Mr Joshi’s confidence, L&C retains a higher weighting in fixed income than most wealth managers – though this allocation is considerably lower than before. A typical private client portfolio is 40 to 43 per cent invested in the asset class – 3 to 4 per cent below the neutral position. This compares with an allocation of 5 to 10 per cent above neutral between 2011 and the first half of 2013. Mr Joshi asserts that “fixed income returns this year are pretty attractive” – with L&C making a 3 to 4 per cent return on its fixed income allocation so far.

L&C is, in common with many other wealth managers, increasing its position in dollar-denominated emerging market debt. It is concentrating on three Brics countries – Brazil, India and China – where it sees selective value in particular well-run companies. Yields on 10-year bonds for relatively attractive emerging market companies can, Mr Joshi notes, be as high as 9 per cent. Although investors must venture into junk bond territory to earn these returns, he says that several sub-investment grade companies in emerging markets that are offering dollar debt at high yields are fundamentally sound. These include Chinese real estate company Country Garden and State Bank of India.

Two of these countries, Brazil and India, are in the ‘Fragile Five’ – the countries deemed most at risk of financial crises as the US Federal Reserve continues to make its monetary policy less loose. However, wealth managers’ interest in these investments reflects a sense that in the long term, India and a number of other members of the Fragile Five have strong underlying economies. Private bankers acknowledge that in the meantime investors in such bonds should fasten their seatbelts for a bumpy ride – making emerging market bonds good long-term but poor short-term tactical investments.

In much of the world commercial property has already had its bumpy ride, in the years after the credit crunch, taking a much smoother path since. In addition, having landed at the bottom with a resounding bump, property prices are now seen as attractive because valuations, relative to income, are no longer as stretched as before the credit crunch.

Investors see opportunities, for private clients, in both lending and ownership. When it comes to lending, Pictet’s Mr Campiche notes: “The risk of commercial property is reduced by the fact that collateral has in some cases dropped by 50 per cent in value.” Commercial property lending can, he says, generate yields of 7 to 9 per cent.

Real estate is also favoured by Berry Asset Management. the London-based subsidiary of Swiss private bank Bordier & Cie. “Commercial property could see a renaissance in investor interest given its attributes of income provision, long-term capital appreciation and generally low volatility,” says Jamie McLeod, chief executive of Berry AM.

Many alternatives to fixed income, such as absolute return strategies, are available largely through investment in hedge funds. But many private clients have been burned by this route before.

Pictet’s Mr Campiche warns sternly against underestimating the risks of hedge fund investment, for those investors seeking substitutes for conventional fixed income. He notes, for example, that relative value strategies tend to require high leverage in order to make a decent profit from generally quite minor mispricing. As a result, an unexpected and large change in prices can create large losses.

It is, at the end of the day, possible to be a little too zealous in trying to find substitutes for conventional fixed income – whether this is through more exotic bond investments or other yield-producing assets. Private clients can, however, avoid the potential traps of these strategies by committing the heresy of chipping away a few bits from their rocks of wealth – in other words, by selling assets.

“There’s nothing wrong with clients eating the gains in their equity portfolios – which were sometimes up 30 per cent over the past year,” says Mr Flahive of BNY Mellon Wealth Management.

Some private bankers argue that if clients sell only enough to realise recent market gains they are not, in some respects, going against the fundamental tenet of wealth preservation. On the contrary, some believe that by avoiding riskier unconventional strategies clients are, perhaps, increasing the chances of wealth preservation. Changing times sometimes call for conversion to old heresies.

Predicting the path of rising interest rates

There is much talk among investors of the coming rise in interest rates, but how fast and steep is their ascent likely to be?

“Increases in market interest rates will be modest because policy rates will remain modest for a very long time in every part of the world,” says Amin Rajan, CEO of Create-Research, a UK-based asset management think-tank.

“In this situation, the potential losses on government bonds are not likely to be very significant.”

Even if rates are not likely to rise very fast, however, private clients still cannot afford to content themselves with government bonds, given their low yields. Mr Rajan says that because of these yields, many of them “are moving up the frontier of risk to somewhere in the middle” – not into equities but into higher-yielding forms of credit.

However, Mads Pedersen, co-head of asset allocation at UBS Wealth Management in Zurich, believes market interest rates could rise quite rapidly, because of the desire of central banks to “normalise” rates. UBS forecasts that, because of increases in the Fed’s policy rate, in five years time the yield on the US Treasury 10-year will be more than 4 per cent – which Mr Pedersen regards as a satisfactory rate for investors. This could, however, happen well before five years are up, he says.

Within fixed income allocations, Mr Pedersen sees a strong possibility of a rotation back from high yield into government bonds within three years.

For those who cannot decide what the path of interest rate rises is likely to be, one option is to circumvent the problem by buying bonds and holding them to maturity. Arnaud Gandon, chief investment officer at Heptagon Capital, a UK-based investment management company, has invested in a specialist fixed income manager which buys high-risk two or three-year bonds on this basis.

With such an investment technique, he notes investors do not need to consider the normal fears of bond buyers, such as the long-term market position of the company, or the future path of interest rates.

“The name of the game is simply to ensure that no default will happen within a two or three-year period,” he explains.