By Salman Ahmed
If investors faced a difficult investment environment before Brexit, the challenges they now face have intensified. In our view, a potential UK recession looms, the “Japanisation” of Europe is increasingly likely and central banks will be more cautious on both sides of the Atlantic.
Central bank action will continue to dominate. We believe in Europe the ECB will increase both the duration and scope of its asset purchase programme in coming months, even though the pool of available securities continues to shrink. The Fed is likely to tread a more cautious path, possibly holding rates until next year.
While this intensifies the search for yield, pushing investors to take more risk, there is a concurrent increase in tail risk driven by lower liquidity, slower growth, policy noise and more uncertainty. In today’s new reality, fixed income is no longer a safe hiding place – yields are increasingly negative, diversification is decreasing and the liquidity is reduced.
Indeed, market risk has increased as yields fall further into negative territory. Around USD10trn in government and corporate bonds are now yielding less than zero.1 Investors have to take on increasing duration risk to potentially achieve positive yields – over 50 years in the case of Swiss sovereign bonds. With correlations between bonds and equity also in positive territory, bonds can amplify, rather than diversify, risk in portfolios.
Fractured liquidity also adds a growing risk element to portfolios. Central banks may be accumulating even more of the available free float, reducing liquidity. Dealer inventories, which have collapsed since pre-crisis levels, may also come under growing pressure from regulation, especially as Basel III will be fully implemented over the next three years. Damaged liquidity reduces the market’s ability to provide fundability between cash and bonds. Investors will be less confident of their ability to exit positions and may pay high costs to do so.
In the context of disinflation, low growth and the search for yield, we think it is increasingly important not to fight the central banks. Investors have no influence on the direction of regulation, which continues to tighten, on the quality of communication or the policy objective function of certain central banks. In our view, portfolio construction is the best tool to adapt to the new reality and prudence is the name of the game – building ‘buy and maintain’ portfolios that trade less, reduce duration risk and limit access to poor liquidity instruments, and create additional diversification.
In fixed income markets, the status quo is for market-capitalisation-weighted portfolios, which reward leverage. This model leaves investors increasingly exposed because fractured liquidity implies more frequent liquidity-based accidents in the foreseeable future and during those events, we believe investors will find exiting positions more difficult and costly.
Therefore, rather than mitigating liquidity risk, investors should focus on investing with fundamentals and bring default risk mitigation to the heart of portfolio construction in their efforts to reap additional yield to meet return targets. Investors could also consider moving away from using risk and return as their only metrics, and look at outcome-based methods that maximise the return for a given level of risk but also consider the sources and the liquidity profiles of those returns. For example, when liquidity is expensive, diversifying across assets of varying liquidity profiles improves the scope for capital preservation and the ability of the portfolio to cover unexpected liquidity needs.
The search for yield also implies looking for bond-like substitutes and in this regard, multi-asset portfolios built on risk-based portfolio construction with a strong focus on drawdown management can bring a lot to the table. They address many of the key issues in fixed income markets by providing maximum diversification of both traditional and alternative risk premia, reduced sensitivity to interest rate movements and liquid, transparent and scalable implementation.
In today’s new reality where fixed income portfolios no longer fulfil the same role they once did, investors may want to consider what alternatives are available to provide shelter from growing market risk, lack of diversification and fractured liquidity. A prudent approach to portfolio construction puts fundamentals and liquidity risk front and centre.
Salman Ahmed is chief investment strategist at Lombard Odier Investment Management
