The right way to integrate fixed income

The equity bull run is over, so advisors have to shift focus to fixed income, said a panel of financial experts at a recent Alternative Investment Management Association (AIMA) luncheon.

The consensus among investment managers is markets will likely sit along the bottom for the next couple of years. So depending solely on equities will limit returns.

But the case for fixed income isn’t too compelling. So far, the biggest arguments against the asset class are low interest rates and sub-par performance.

Andrew Torres, founding partner & CIO, Lawrence Park Capital Partners, says it doesn’t take much to have negative returns on a fixed-income portfolio, for instance.

“Volatility is out there and the coupons you’re earning against that volatility are at historic lows.”

Portfolio managers, he adds, should try to separate fixed-income risk into credit risk and interest rate risk. Then, hedge away the interest risk component and manage the credit risk by focusing on generating returns through active management.

Additionally, equities have a lot of beta, so fixed income is a viable alternative to that because credit is low-beta equity.

“We’re in a very risk-on, risk-off environment, and in the risk-off world all equities get hammered,” says Torres. “If you’re a prudent and active manager of a credit portfolio, you can actually generate pretty healthy returns but in a much lower-beta environment.”

Leverage: bogeyman or blessing

Post-2008, leverage became a dirty word, especially in the mainstream media. And with investors turning more risk averse, leveraged investments became exceedingly undesirable.

Read: Interest returns to leverage strategies vs. Regulators rein in advisors on leverage

But you shouldn’t think of leverage or derivatives as the bogeyman of the financial markets, says Kevin Dribnenki, portfolio manager, Ontario Teachers’ Pension Plan.

He focuses more on how risk is being managed, rather than on how much leverage is involved. “There could be lots of leverage and very little risk in some cases, and very little leverage and lots of risk in others.”

Dribnenki says risk can be better managed if investors are able to track how much leverage is used in a fund.

Torres agrees, saying there are a lot of misconceptions about leverage. He says it can play a meaningful role in a portfolio.

If investors seek diversification and exposure to both interest rates and credit—two different bets—just being in an unlevered high-grade bond portfolio is not going to cut it, he adds.

“And if you’re going to play in a high-grade [bond] portfolio, then you should be prepared to take some leverage to get some return. The driver of those returns is very much going to be about interest rate volatility. In a high-yield [or junk bond] portfolio, on the other hand, you start to cross over into the area where credit outweighs interest rates.”

Read: Tap Canadian junk bonds and Investors demand junk bonds

For the best risk-adjusted returns, an investment portfolio should diversify in both areas.

Dribnenki says many of the smartest money managers in the country are in the fixed-income space, and they’re the ones who have been successful in picking their way through market volatility.