Defensive Diversifiers: Seeking Low Risk Yields
As we approach the end of the economic cycle, some investors are increasingly looking for a defensive positioning in their portfolios. Investment opportunities have shrunk since central banks adopted negative rates in the eurozone and Japan. Slightly more than 20% of global bonds have a negative yield-to-maturity. However, there are still solutions that offer positive expected returns for a relatively low level of risk.
Diversification reduces the overall risk of a portfolio. We diversify assets in a number of low-risk products and others with a calculated risk.
Defensive investors are likely to favour high quality issuers in their base currency. There is also value in short-term US Government bonds and Emerging Market bonds for those who accept currency risk. Other solutions such as structured products, leveraged loans in Europe and Newcits funds may also be considered.
Equities solutions are a bit more risky. Defensive funds such as buy-write funds offer partial market exposure to limit risk.
Investors with a low risk profile used to buy bonds that were deemed safe, such as those issued by governments or large companies with high credit ratings. Those bonds are now expensive, or even have a negative yield-to-maturity, which means in concrete terms that the buyer is certain to lose money if he holds them until maturity. Actually, 20% of bonds worldwide have negative yields. In the eurozone, this percentage rises to 40%! Against this backdrop, we are exploring several solutions that should offer positive returns for investors with low and moderate risk profiles.
In an environment of low interest rates and slow economic growth in the eurozone, investors can find returns in subordinated debt. However, this is more risky than senior debt, since it only comes second in the order of repayment priority in the event of the issuer's bankruptcy. But the positive side is that it offers a more attractive yield. We favour Investment Grade issuers in order to limit the risk of restructuring/default.
For dollar-based investors, or those invested in euros who accept currency risk, short-term US Government bonds are attractive. The Federal Reserve should cut rates twice in 2020, in our view, while the market is discounting only one rate cut, suggesting that short-term rates are likely to drop. Green bonds issued by US companies deserve attention. There is a good supply and yields are attractive. They behave like conventional bonds, the difference being that they finance projects primarily designed to mitigate climate change.
Finally, Emerging Market bonds remain attractive: both Corporate bonds in hard currency and Government bonds in local currency. This asset class is supported by the search for yield as developed countries offer only low or even negative yields. The indices are now highly-diversified, which means that the risk is not as high as in the past. Emerging Market currencies are undervalued according to us, so the currency risk is small.
In an environment of low interest rates, leveraged loans in Europe offer an attractive risk/return and a natural protection against the risk of rising interest rates since the income generated is based on variable interest rates. Traditionally, the asset class has low volatility, but is not immune to the potential volatility of other asset classes. Senior loans are the safest part of the capital structure, so defaults should be scarcer in this part. Liquidity can be low, so it is recommended to invest over a long period.
Newcits funds offer the asset manager the opportunity to benefit from the increase (or decrease) in asset prices depending on the strategy. We favour macro strategies because trade tensions and populism are challenging some sectors, which should generate volatility and therefore opportunities. In addition, the dispersion between Emerging Markets helps to foster investment ideas. Long-short equity strategies are also attractive because they can exploit structural factors such as low yields and disruptive innovations.
Buy-write funds are intended for defensive investors. They offer exposure to the equity markets with the objective of reducing risk through the use of options (sale of call options). These funds participate less in rising indices in bull markets but mitigate declines in bear markets. Their return is generally less volatile than traditional funds.
These products use sophisticated instruments, such as futures, options and credit default swaps (CDS) to which individual investors typically have limited access. Structured products can be built with a 100% capital protection for very defensive investors or with a risk on part of the capital. Investors can benefit from the difference between short-term and long-term interest rates or generate returns by focusing on movements in implied volatility. Structured products in euros are less attractive than those in dollars due to low interest rates in the eurozone.
The risks of the ‘defensive diversifiers’ theme are mainly opportunity costs in the event of risky assets continuing their upward trend.
The risks inherent in the product offered are risks related to a sudden rise in interest rates, the default of an issuer, reduced liquidity in the event of market tensions, or exchange rate fluctuations. We will seek to limit these risks with short-term bonds and by favouring high quality issuers.