Tilting away from traditional fixed income

Fixed-income investors face a double bind: alongside persistently low bond yields in recent years, they must also now contend with the prospect of increasing interest rates.

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“We are not only in a low-yielding world, but we’re also in one where […] we’re projecting a trend of higher rates,” said Samuel Lau, a portfolio manager with Los Angeles–based DoubleLine Capital, in an interview on May 4.

“When we start off with a lower yield, you have less income to protect your portfolio from changes in interest rates.”

On the plus side, the economic recovery is generally supportive of credit, he said.

Still, to effectively navigate the fixed-income market in 2021 and beyond, investors must manage interest rate risk in their bond portfolios, said Lau, whose firm manages the Renaissance Flexible Yield Fund.

To do this while also earning income, Lau looks to non-traditional credit.

Examples include structured credit such as non-agency residential mortgage-backed securities, commercial mortgage-backed securities, and other asset-backed securities within infrastructure or transportation.

“These are areas that you can still find relatively attractive yields — in some cases above 4% — while still remaining investment-grade rated,” Lau said.

He also listed collateralized loan obligations, with their “relatively attractive” yield-to-duration profiles.

With these non-traditional options, however, investors should be mindful of credit risk, Lau said. Also, with the run up in prices, “you need to be able to shake out those mispriced assets that still have good value in them […] from the ones that are grossly overpriced,” he added.

A well-diversified fixed-income portfolio could also include “a little bit” of high yield and bank loans, he said, as well as other discerning choices within non-investment-grade credit. Further, attractive yields can also be found in emerging markets sovereign debt.

For investors whose main objective is to generate income and who can hold their positions without panicked selling at inopportune times, Lau suggested seeking professional advice.

“That way, you can pick up some income,” he said. “You can also manage your interest-rate risk, as most of these credit-sensitive sectors of the market do have less interest-rate risk and should do better in a rising-rate environment, all else equal.”

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Staff

The staff of Advisor.ca have been covering news for financial advisors since 1998.