The biggest risk in fixed income portfolios is not interest rates. It’s equity risk.
Jeff Rosenberg, chief investment strategist for fixed income at BlackRock, made the case for this argument during a panel discussion Wednesday at the UBS CIO Forum in New York.
“What’s going on in portfolios is not that people are taking on too much interest rate risk,” Rosenberg said. “It’s that people need income, and the fixed income solution … to get income you can’t get it out of fixed income risk [and] you can’t get it out of duration measures.”
What are people doing to get income from a fixed income portfolio right now?
“The way at which you find income is by taking on equity risk inside the fixed income portfolio,” Rosenberg explained. “So you see massive increases in the percentage not of duration held by mutual funds but of credit risk held by mutual funds. Because you have to reach your yield.”
Joining Rosenberg on the panel was Michael Roberge, co-CEO, president and chief investment officer at MFS Investment Management, for a volatile discussion on the volatility and risk of fixed income in the inevitable rising rate environment.
“There’s reason to hold fixed income assets in a portfolio – it is for income; it’s also to balance against some of the other risks, in particular equity assets in a portfolio,” Roberge said.
While the implication is that fixed income is used for balance in a portfolio, Rosenberg argues no one is operating that way because they need income.
“Which means there’s an essential trade-off you’ve made, knocking off the balance to get the income,” he said, adding, “People are overallocating to taking on equity risk inside their fixed income portfolios at the same time they’re max-allocating to equities.”
Meanwhile, it is Roberge’s and MFS’ view that investors should be underweight their long-term allocation to fixed income currently, given the starting yield levels today.
“You take the long view and you look at where equities are relative to fixed income,” Roberge said. “Clients/investors/financial advisors/others are going to make better returns in the equity market in the 5- to-10-year period than they are the fixed income markets. And you do need to think about protection in an environment where the Fed is going to hike rates.”
Roberge says rates will go up “some” – albeit the rise will probably be capped because of quantitative easing around the world, he added.
“I do think that you need to be very careful in the rate markets now and should actually think about alternatives to some of the markets,” Roberge said.
Another panelist, Krishna Memani, chief investment officer at OppenheimerFunds, agreed with Roberge that fixed income assets are volatile.
“But, let’s not overstate that volatility,” Memani said. “The fear of interest rates is a genuine fear. It’s something we should definitely think about, but I think we should not let it paralyze us.”
Memani believes volatility shouldn’t necessarily deter someone from holding fixed income in a portfolio. “If you look at the medium-term performance of government bonds or if you look at the medium-term performance of credit assets, they really have been quite good,” he said. “And I think given the outlook from a growth standpoint and given the outlook from an industry standpoint, I think fixed income can still provide you decent returns. It’s just that it won’t be as large as it has been historically.”
Memani suggests that, perhaps, the mindset around how to generate income from fixed income needs to change.
“The challenge of generating income is not going away, in respect to whatever our interest rate outlook is. Finding ways of meeting that challenge is a challenge that we face every day, and it’s something we in the industry have to find ways of delivering,” Memani said. “Thinking of just yield and thinking of safe assets as the primary source of income from fixed income would not be the right way to approach it.”
But there’s a bigger issue for fixed income, Roberge argues.
“A lot of buyers have been in the market post-financial crisis thinking it’s a safer asset class,” he said. “In a rising rate environment, do they understand the volatility that they’re taking? And I would argue that most investors don’t understand that, and that’s the risk we’re going to see in the fixed income markets when rates rise.”
— Check out Fed Says Labor Market Improves as It Moves Toward Rate Rise on ThinkAdvisor.