Building Resilience in Fixed Income Portfolios
BlackRock’s experts weigh in on different approached to a common goal
An aging cycle, rising geopolitical risks and heightened market volatility all seem to threaten the ability of investors to reach their objectives. One major result is a renewed focus on the concept of portfolio resilience—always good to have, but especially important now.
Widely used these days, the term “resilience” sometimes connotes a defensive bias. BlackRock believes there’s more to resilience than that. Investors need to participate on the upside as well as to mitigate the downside. A truly resilient portfolio should be consistent, diversified, risk aware, and flexible, with the ability to effectively navigate short-term shocks while capitalizing on long-term trends.
How do you build a fixed income portfolio that has these attributes under current market conditions? There is, of course, no one-size-fits-all answer. But considering the question from multiple perspectives can help to bring potential solutions to light. To that end, II asked two BlackRock experts – Rick Rieder, Chief Investment Officer and Co-Head of Global Fixed Income, and James Keenan, Chief Investment Officer and Global Co-Head of Credit – for their thoughts on building resilience for the long term.
How do you build a resilient fixed income portfolio in today’s environment?
Rieder: We’re really focused on what I call efficient portfolio construction. We run some very sophisticated analytics to assess things like beta risk, volatility and dispersion, with an eye toward understanding how all of the assets in a portfolio are interrelated.
One very important theme that arises from this analysis is the renewed role that Treasuries can play as a hedge in a portfolio. In this environment, we think interest rates are likely to remain range-bound for the near term, which means investors can once again use duration as a hedge to build more durable portfolios. At the same time, we’re faced with a slower global growth dynamic, so we think it’s important to be cautious around credit risk. We have a high-quality bias across our allocation to credit that we rely upon to source durable income. In areas like high-yield, we are very selective and favor idiosyncratic opportunities rather than broad index exposure.
How do you approach risk management in your portfolios?
Rieder: We believe in casting an extremely broad net in search of returns and in taking a cautious, deliberate, and flexible approach to both investment selection and risk management. We avoid concentrated bets and instead seek out the many and diverse sources of alpha that markets offer. In our experience, targeting a wide array of incremental return opportunities, without being tied to a benchmark, can help keep volatility low while enabling investors to seek returns across different market environments and cycles.
We also spend a lot of time looking at marginal contribution of risk. We want to understand how every individual asset and every sector that we’re considering adding to a portfolio would impact the risk of the overall portfolio. If you can understand that, we think you have a much better chance of building a stable, resilient portfolio that doesn’t experience massive up and down swings, even when markets come under pressure.
Our goal is not necessarily to have the best performance in up markets, but we definitely want to avoid having the worst performance in down markets. We want to create consistent returns for our clients, and the portfolio construction and risk management strategies that I just described really form the backbone of our approach.
Which market or macro risks are you most concerned about?
Rieder: There are two things that come to mind. The first is China—I think a lot of people underestimate how important China has become to the global economy and, by extension, to global financial markets. When you look at China’s contribution to global growth, its importance to commodities markets, the amount of debt on its books—these are all variables that can have a tremendous impact on market outcomes. To be clear, I don’t think China is headed for an imminent hard landing, but I do think that investors need to monitor the situation there very closely if they want to build resilient portfolios.
The second risk is what I call short-volatility liquidity. There are many more ways to take a short position in volatility than there were in the past, and a lot of investors piled into various short volatility trades over the past several years of relative market calm. But when markets come under stress, the liquidity in a lot of these trades can evaporate. So I think you need to be really careful about how you manage your liquidity, how you diversify your portfolio, and how those decisions will impact your performance in unstable environments.
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Credit is often viewed as a risky asset class. How can an allocation contribute to the resilience of an investor’s overall portfolio?
Keenan: We view credit as a strategic asset in a broadly diversified portfolio. Credit exists in the space between equity risk and traditional fixed income. Equity returns are based on expectations of future earnings, whereas sub-investment grade credit returns are based on the likelihood of default. Both returns factor in earnings expectations, but because credit is senior to equity in the capital structure, an allocation to credit may reduce the volatility and drawdown risk associated with an equity portfolio.
From the perspective of a bond investor, adding credit to a fixed income portfolio can introduce diversifying sources of risk and return. For example, an allocation to credit can be used to reduce duration and make the overall portfolio less susceptible to changes in interest rates.
How should investors be thinking about allocating to credit given where we are in the cycle?
Keenan: I think you need to start with a historical perspective. For many decades, we were in a boom-and-bust environment that culminated in the global financial crisis. During that era, it was critical to move to a much more defensive position as we got later in the cycle in order to invest after the dislocation or the pullback.
We’re always going to have credit cycles, but we think that an important shift occurred after the financial crisis. In the last ten years, we’ve seen assets and leverage move from the household sector and the banking sector onto government and central bank balance sheets. When we think about that structural change, we believe that the end-of-cycle tail risks and liquidity-shock risks are lower than they have been historically. We think the cycles are probably going to be more frequent and milder to both the upside and the downside.
So, if we’re no longer living in a boom-and-bust world, but we are living in a world of low growth, low returns and low inflation, we believe there is a strong case to be made for a long-term allocation to credit.
How are you looking to build resilience in your portfolios in the current environment?
Keenan: We believe in looking across the full spectrum of credit opportunities. Credit is an asset class that has become more accessible to investors over the past decade as the market has grown and bank financing has shrunk. This larger investable universe allows you to build resilience through diversity across industries, geographies and liquidities.
At this late stage of the credit cycle, we look for companies with stable cash flows in non-cyclical industries, and in our liquid portfolios we have a higher-quality bias. We also take advantage of the growth of credit markets in Europe and Asia to gain exposure across different stages of the economic cycle. And by giving up some liquidity, we see opportunities to pick up additional yield for comparable credit quality in the private market.
We think the global monetary-policy environment will extend the current credit cycle, and the risk of recession has come down from last year. This is a supportive environment for credit. Nevertheless, we’re still underweight companies in cyclical industries and those with already slow earnings that we think would suffer the most if economic growth slows.
You mentioned private assets. What role can they play in a credit portfolio?
Keenan: If you believe that we’re going to be in a low-growth, low-return environment for some time—and we do—then I think you have to ask yourself how you’re going to meet your long-term return objectives. Trying to achieve reasonable return targets in this environment requires taking on some additional exposures, in our view.
When you move into private markets assets like direct lending, opportunistic credit or dislocation strategies, you may be able to harness an illiquidity premium or a complexity premium, on top of the spread premium that you’re getting in public markets. This can obviously improve your long-term return profile, but it can also improve the resiliency of your portfolio via exposure to these diversifying sources of return.
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