Market Review & Portfolio Positioning
While equities rallied over the last month following the Brexit shake-up, little has changed in the underlying fundamentals. Developed economies are near their cyclical peak and continue to flip-flop between expansion and slowdown in our regime framework, while some emerging economies continue to recover. Valuations are above average on many assets, with emerging equities and credit among the relatively more attractive in our view. The one notable change is that market volatility has declined significantly over the past month. Given this continuity from last month, we maintain the following tilts in the portfolio:
- Slightly underweight equity, with a preference for emerging over developed equities given more attractive valuations and cyclical improvements;
- Neutral in terms of interest rate duration;
- A significant allocation to income generating assets.
A Closer Look at Our Income Assets
Given that our views and positions are similar to those from July, this month I want to take a deeper dive into our holdings in income assets. As the market cycle matures and potential returns from many asset classes appear modest, we believe these income assets offer attractive levels of income, low to moderate volatility, and diversification to the portfolio. Further, demand for income assets is likely to remain high given low yields on government bonds, and our analysis indicates that the credit cycle still has room to run. As shown below, these assets have recently offered attractive returns with significantly less volatility than global equities.
High Yield Corporate Debt
The first component of our exposure to income assets is in high yield corporate debt. U.S. high yield currently offers income of about 6.5%, or more than 5% above comparable Treasuries, which is near its historical average. In addition, high yield typically exhibits less than one-half the volatility of equities. Of course, we also note that high yield has delivered double-digit returns year to date, as it recovered from very depressed levels earlier in the year, and we do not expect a continuation of such high returns going forward.
The second piece of our income allocation is in loans. Loans are even less volatile than high yield historically, and currently offer yields of nearly 6%. At these levels loans may offer better value than high yield today, as they are senior in the capital structure, providing more support in the event of a deterioration of credit conditions.
Of course, both high yield and loans are sensitive to movements in the equity market, as equity is the cushion between creditors and the potential impact of a default. But the final element of our income allocation, event-linked bonds, commonly known as catastrophe or “cat” bonds, is not. In fact, I would argue that cat bonds are one of the most durable sources of diversification across the investment spectrum. While nearly all other asset classes are driven by the ebb and flow of the market cycle, cat bonds are a form of reinsurance against natural disasters, which are inherently uncorrelated to the market cycle. Cat bonds currently offer yields over 5% and, like loans, they are floating rate securities, so they have limited interest rate risk.
In combination, we believe these income assets provide attractive, low volatility sources of return for the portfolio in today’s low yield environment.
Visit our Global Multi-Asset Group webpage for additional insights about asset allocation and multi-asset investing.
The MSCI ACWI is a free float-adjusted, market-capitalization-weighted index that is designed to measure the equity market performance of developed and emerging markets.
The Barclays Global High Yield Bond Index covers the universe of fixed rate, non-investment-grade debt.
The Swiss Re Cat Bond Index is constructed to track the total return for U.S.-dollar-denominated catastrophe bonds.
The Credit Suisse Leveraged Loan Index is a composite index of senior loan returns representing an unleveraged investment in senior loans that is broadly based across the spectrum of senior bank loans and includes reinvestment of income (to represent real assets).
Fixed income investing entails credit and interest rate risks. When interest rates rise, bond prices generally fall. Event-linked securities otherwise known as Cat Bonds are fixed income securities for which the return of principal and interest payment is contingent on the non-occurrence of a trigger event that leads to physical or economic loss. If the trigger event occurs prior to maturity, event-linked securities may lose all or a portion of its principal and additional interest. Diversification does not guarantee profit or protect against loss.
Mutual funds are subject to market risk and volatility. Shares may gain or lose value.
These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.