High risk debt

We review portfolios for our clients. Usually our client has a prospect and wants some help demonstrating ways we can improve the portfolio. One consistent trend in these portfolios that we’ve seen over the last few months is that people are coming to us with increasing allocations to the high risk ends of the fixed income spectrum. And the asset allocations that we’re seeing from multi-asset investors and asset consultants are increasingly showing big allocations to high yield, syndicated loans and other forms of risky debt in place of government bonds and investment grade credit.

Now, this is not unreasonable: government bond yields are very low, and if you have a return target to meet, you might want to increase the risk of the portfolio rather than fail to meet your targets. And, over the cycle, the average return of these high risk investments should certainly be higher than safer assets.

But the question we always ask ourselves is “is this the best option?” As the chart below shows, these sorts of assets can experience substantial drawdowns in times of equity market stress. If an investor is willing to look through the short term volatility in favour of higher returns over the long term, why not adjust the whole portfolio? In other words, why not just move to a higher risk profile and increase the equity allocation in the portfolio instead of hiding additional risk in the part of the portfolio that is supposed to be defensive?

So that leads us to ask when an investor would be happier investing in high risk credit instead of equities or safer bonds? If the outlook is really poor, you’d prefer safer assets. And if growth continues as normal, you’d want the additional upside from equities. The kind of scenario that would be best for high risk credit would be an increase in bond yields severe enough to crunch equity market valuations but not severe enough to cause a recession. Or a sustained period of growth so low that equities don’t grow earnings, but not so low that the weakest companies face an increased risk of bankruptcy.

We can imagine these scenarios, but they seem unlikely. For our portfolios we still prefer to take our risk in equities, where we get the extra reward of earnings growth if things are good, and keep the defensive part of the portfolio in safer assets. We vary the proportions of these asset classes dynamically, but if investors need to meet a particular return goal above what’s achievable from the current allocation we advocate increasing the risk profile of the whole portfolio, rather than one part of the allocation.

Important Information: This document has been prepared by Aequitas Investment Partners ABN 92 644 165 266 (“Aequitas”, “our”, “we”), a Corporate Authorised Representative (no. 1284389) of C2 Financial Services, (Australian Financial Services Licensee no. 502171), and is for distribution within Australia to wholesale clients and financial advisers only.

This document is based on information available at the time of publishing, information which we believe is correct and any opinions, conclusions or forecasts are reasonably held or made as at the time of its compilation, but no warranty is made as to its accuracy, reliability or completeness. To the extent permitted by law, neither Aequitas nor any of its affiliates accept liability to any person for loss or damage arising from the use of the information herein.

Please note that past performance is not a reliable indicator of future performance.

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