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13 Apr 2015

What to do with your fixed income allocation

 
YOU USED TO SLEEP WELL

Many portfolios have a fixed income component with a mixture of Government and High Grade Corporate bonds. And for good reason – looking at the US, UK and Germany, a government bond portfolio with a term of about 5 years has provided solid income in the past with total returns in excess of inflation. Risk was relatively modest too, with a volatility in the range 3 to 5% and drawdowns not much more than -5%. These really were “sleep-well” investments.

HOW ABOUT NOW?

My name is Bond …  Negative Yield Bond.

Joking aside, what about bond holdings looking to the future? As of mid-April 2015, the 5 year Government bonds of the US, UK, Germany and Switzerland yield 1.42% in USD, 1.20% in GBP, -0.13% in EUR and -0.48% in CHF respectively. So whilst they are still a store of wealth and represent some of the safest investments imaginable, the risk/reward ratio is now skewed badly against the investor. If interest rates do rise quickly, the drawdown will push this part of the portfolio underwater and the recovery will take some time with such low coupons.
What can investors do? Going out along the yield curve to longer duration bonds is also not rewarded currently. For example as of mid-April 2015, the 10 year German Bund has a coupon of just 0.5% and a yield of 0.15% and the 10 year Swiss government bond yield is negative. Increasing duration also increases the risk of the bond portfolio as sensitivity to rising rates is greater.

Similarly, increasing the credit risk to pick up additional return no longer helps as much as it used to now that credit spreads are at historical lows. And one wonders about the liquidity risk of credit should there be a rush for the door.

So what can investors do with this portion of their assets? Clearly some have already gone into equities, especially those with high dividend yield, as seen by the rally in European equities since the start of the year, but this greatly increases risk in portfolios as equities come with about 3 times the volatility of those bonds and much higher drawdown risk.

THE SOLUTION

QLAB’s solution to this problem is a multi-asset absolute return strategy with the same risk profile as those bonds. The QLAB Asset Allocation strategy targets exactly this risk space and acts as a replacement for medium term bond portfolios.

With a risk budget of up to 6% volatility the strategy invests at least 50% in fixed income, but it has variable duration from 5 years down to zero in order to reduce risk when interest rates rise. The rest of the strategy is allocated across equities by sector and certain commodities using a highly disciplined risk management process to exit those assets during downturns and limit the drawdown risk to be far lower than equities. In a crisis, the allocation can go to 100% cash to protect capital when all assets are falling at the same time.

The result is a portfolio with an expected return of 3 to 4% above the risk free rate over a market cycle after fees without introducing more risk than a medium term bond portfolio from a historical perspective. Actually looking forward it will carry less risk if interest rates do rise quickly.

The strategy is published as an investable index at www.qlabi.com/qaa and QLABQAA on Bloomberg, and investment access is possible via the QLAB Convexity Fund, a Luxembourg AIF managed by our investment management partner RPM Risk and Portfolio Management. With daily liquidity, full position transparency and low cost it is available in USD or currency hedged into EUR, GBP and CHF.
 
So Mr. Bond, this is one villain you can easily deal with.
 
Contact us for more information.
 
The author Dr. Steven J. Bates is CEO of QLAB Invest Switzerland Ltd., an innovator of active investment strategies. Strategies are published as investable indices and investment access is available via regulated product providers.

www.qlabi.com
or Bloomberg: QLAB <GO>

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DISCLAIMER: This document does not constitute an offer, a solicitation, an advice or a recommendation to purchase or sell any investment products associated with the material described herein. The purpose of this document is to describe the principles, research and ideas behind the QLAB Invest strategy indices. Prior to an investment in any product tracking a strategy index, you should make your own appraisal of the investment risks as well as from a legal, tax and accounting perspective, without relying exclusively on the information provided by QLAB Invest. Investment products tracking the indices must be issued or/and marketed by a regulated company. This document is strictly for informative purpose. The single source of the underlying asset data is Thomson Reuters Datastream and QLAB Invest cannot guarantee the correctness of the underlying asset data and cannot be held legally responsible in this regard. Any references made to historical performance up to the official live inception do not reflect actual live performance and can be subject to selection, curve fitting and other statistical biases. Performance in investment products linked to the indices may be reduced by the effect of commissions, fees or other charges in excess of those already factored into the index calculations. The level of the indices will fluctuate due to the volatility of the underlying exposures and past performance or volatility is not necessarily indicative of future results.