Sunil Krishnan asks whether higher-yielding fixed income assets remain good diversifiers for multi-asset portfolios in the current environment.
Higher-yielding fixed income asset classes performed very strongly for portfolios in 2019. For much of the year, they were more attractive than equities, offering high levels of yield and less need for acceleration in the global economy to deliver excess returns and see tightening spreads.
In 2019, global high yield delivered almost 13.51 per cent and emerging market hard-currency sovereign debt close to 14.52 per cent returns. In a multi-asset context, these asset classes are also attractive through their ability to diversify portfolios. They offer a different source of risk and return than developed-market equities and government bonds.
However, such a period of strong performance raises the question of whether the thesis remains as compelling today.
On the one hand, the decline in yields we have seen in 2019 makes it less likely that significant capital gains will continue into next year; but on the other hand, current levels of income still look attractive in a scenario where defaults do not increase significantly.
Figure 1: Global high yield and emerging-market debt yields
The degree of diversification on offer against more mainstream assets is another area which has changed. The increasingly tight relationship between global high-yield returns and global equity returns is a factor now affecting our construction of multi-asset portfolios. By contrast, the relationship between emerging-market debt and developed-market assets has remained more differentiated.
Figure 2: Global high yield and emerging-market debt yields correlations
We do not expect returns from emerging-market debt to come in significantly above their coupon. For the asset class to deliver further significant capital gains, it would likely require a meaningful move lower in the US dollar, and this isn’t our central case as the US Federal Reserve seeks a pause in its easing cycle. Yet any changes here might provide an additional return driver, particularly in local-currency emerging-market sovereign debt.
Overall, through the market cycle, both emerging market debt and high yield clearly deserve a strategic role in portfolios as a source of growth and diversification, but at this point emerging market debt appears to offer stronger overall portfolio diversification.