Eight years after the “Great Recession,” financial markets have stabilized and global equity prices have risen with the help of a liquidity boom by central banks. That, however, has not managed to return real economic activity back to pre-recession levels.
The U.S. economy also has not responded to the dramatic stimulus. In an echo of the Great Depression, the Federal Reserve has been pushing on a string, operating with a weak accelerator but a powerful set of brakes. Despite massive stimulus, inflation indicators remain muted, slowing the Fed’s plans to reverse the stimulus. This suggests there are forces at play today that were unknown in previous cycles.
Those forces appear to be an unusually high level of debt in the economy, coupled with an evolving demographic profile of aging baby boomers who are now exerting considerable pressure on labor force growth as they move into retirement. Weak productivity has also hampered economic activity, all conspiring to define the most challenging time many asset allocators have experienced in their lifetime. For investors hunting for income, it means a time to adjust.
Investors may face a host of risks in today’s credit markets. Return expectations for the Bloomberg Barclays U.S. Aggregate Bond Index are near all-time lows, yet its risk profile is at an all-time high. With average duration at six years, that risk/reward tradeoff is challenging historic extremes.
Meanwhile the size of the corporate bond market has increased by 75 percent to $8.5 trillion since 2008. Years of low rates have prompted companies to issue more and more debt, weakening their balance sheets. And, due to increased demand for higher-yielding debt, covenants designed to help protect investors have been relaxed. Lastly, liquidity has shrunk significantly due to financial regulation put in place after the financial crisis, leaving the corporate bonds vulnerable to price shocks.
All of this has led to traditional fixed income no longer being the go-to asset class for income and stability of yesteryear. Where can investors go from here?
Many investors, if asked, may say they look to their fixed-income allocation to provide dual roles of delivering income and portfolio protection from the volatility of equity exposure. There was a time when the Bloomberg Barclays U.S. Aggregate Bond Index could deliver both. But, as that is no longer the case, it may be time to consider reducing duration and diversifying fixed income-exposure to help manage the overall risk profile.
Many investors have chosen to move down the credit quality curve for income, requiring them to assume more credit risk. But a flexible strategy could help balance income generation with solid risk management. A flexible strategy can complement a fixed income allocation with a portfolio that has a lower correlation to stocks and bonds.
With a flexible strategy, investment managers can move down the capital structure to seek a better risk/reward tradeoff, or a more appropriate level of income for the risk taken. It allows them to pursue high current income from markets around the globe, in any capital structure where relative value can be found, with access to a variety of asset classes.
Managers can look at the debt of a company and determine if the better risk/reward profile is with straight debt or preferred debt. They might opt for high-yield debt issued by a company, or to go further up the capital structure for investment-grade fixed income. They can explore the many shades of preferreds, or hunt for quality and income among corporate bonds, asset-backed and mortgage-backed securities or high dividend equities. Derivatives can be used to help manage credit and equity risk. As they move through the cycle, and some opportunities arise while others fade, managers can make shifts in the portfolio to seek that more stable risk/reward profile as the markets change underneath.