Corporate bonds have a key role to play in income portfolios, but investors may be exposing themselves to unintended risks, explains Jordan Sriharan, co-manager of the LF Canlife Diversified Monthly Income Fund.
I have written previously [see A Modern Approach to Income Investing] about the not-insignificant challenges that low interest rates, consequent low bond yields and high asset prices present to income investors.
When it comes to investing in bonds the stakes are high, not least because income investors may be used to thinking of bonds as being a relatively ‘safe’ alternative to investing in equities. Bonds act as ballast in a multi-asset portfolio by providing income and diversification away from equities and also helping to protect capital values during market corrections. However, the decades-long bull market in bonds has pushed bond prices to high levels (bond prices rise when bond yields fall), lulling investors into a false sense of what constitutes ‘security’.
In a bid to maintain the levels of income that they require, many income investors are seeking higher returns on their bonds from less credit-worthy companies. These types of company offer a higher yield in order to attract investors, but investing in them may result in unintended skews towards riskier assets in income investors’ overall portfolios.
With bond prices at historic highs and yields at historic lows, the margin for error in selecting bonds is thin. In these circumstances, relatively small rises in interest rates can have a sizeable impact on government bond prices and, in turn, on an investor’s corporate bond holdings – depending on the industry exposures involved, individual companies’ credit worthiness and when bonds are due to redeem.
What lurks beneath
Just as income investors may have developed an unintended skew towards a number of risks in their equity income portfolios [see Roll With the Times], so too risks may have risen in their bond holdings, but for very different reasons.
The chief risk facing income investors in corporate bonds is the drop in the credit quality of debt that is being issued. In other words, the likelihood of a given company being able to pay the interest it owes on its corporate bonds has been weakening.
One of the consequences of low yields across financial markets is that less credit-worthy companies are able to issue debt at low rates of financing. Whereas many of these less financially stable companies would have found it prohibitively expensive in a world of higher interest rates to pay the interest due on corporate debt, today’s markets have enabled them to effectively borrow money from income investors at extremely low rates.
As the chart below shows, the amount of corporate debt in issue that is just one step away from junk status has never been greater.
Equities in bonds’ clothing
Pursuing higher yields in corporate debt inevitably means lending money to less profitable, more speculative companies. Given the fragility of cash flows generated by these businesses, high yield bonds can be significantly correlated to equity markets and therefore show levels of volatility that are not dissimilar to the volatility typically seen in equities.
This is clearly undesirable, as one of the key roles of bonds in a portfolio, alongside providing dependable yields, is to provide diversification by behaving in a different way to equities across the economic cycle.
Managing risk across all income investments
Our approach to risk management in the LF Canlife Diversified Monthly Income Fund results in a portfolio that does not chase higher yielding bonds to generate income. Instead, we focus on balancing risk across a blend of asset classes to achieve an attractive and sustainable overall income.
In the case of corporate bonds, we look first and foremost at bonds issued by companies that have high credit ratings (known as investment grade bonds) to build the fixed income element of the LF Canlife Diversified Monthly Income Fund’s portfolio.
Investment grade bonds currently account for around 70% of the fixed income allocation that we hold in the portfolio. The balance is in a range of carefully selected higher yielding bonds where we are confident that the risks we are taking on behalf of our investors are fully warranted in terms of the potential upside.
Most of the high yield bonds held in the fund have been issued by a parent company that has an investment grade rating. These bonds are rated as high yield because, in the event of default, they will repaid after other bonds. In this way we are able to access higher yields from companies that have robust investment-grade risk profiles.
We do not rely purely on corporate bonds to provide higher income but also consider the strength and growth potential of income streams available from equities and real assets such as property and infrastructure.
The last of these, real assets, constitutes a smaller but important part of the LF Canlife Diversified Income Fund. However, it is an area of the portfolio that punches well above its weight given the long-term and often inflation-linked nature of the cashflows that are available from areas such renewable infrastructure and long-lease property.
Non-financial investment grade credit market distribution by rating, %
Source: J.P. Morgan, ex-EM issuers. From US HG Credit Ratings Review, J.P. Morgan North America Credit Research, 12th October 2021. Reproduced with permission of J.P. Morgan
Past performance is not a guide to future performance. The value of investments may fall as well as rise and investors may not get back the amount invested. Income from investments may fluctuate. Currency fluctuations can also affect performance.
The LF Canlife Diversified Monthly Income Fund (the Fund) may invest in property funds that may be illiquid and subject to wide price spreads, both of which can impact the value of the Fund. The value of the property is based on the opinion of a valuer and is therefore subjective.
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