Fixed-income investors have been stuck between a rock and a hard place for a while now. Governments’ incredibly easy money policy has sent yields plummeting, forcing many investors to accept negative real returns in their bond portfolios. And with rates so low now, fixed-income investors are vulnerable when rates start rising again (whenever that may be). So what to do? Throwing your fixed-income allocation out the window is not much of a solution for individual and institutional investors alike. The diversification benefits of fixed-income remain as important as ever. At Morningstar’s recent ETF Invest conference in Chicago, Invesco PowerShares' Kevin Petrovcik, WisdomTree's Rick Harper, and Western Asset's Matt Duda tackled how to best improve fixed-income returns by looking to what they see as under-utilised asset classes.
Don't Discount Emerging Markets
Both Harper and Duda talked about the attractiveness of emerging-markets sovereign and corporate debt, especially when compared to United States issuers. Both managers said that many domestic investors have plenty of misconceptions about emerging-markets debt; investors see it as a non-investment-grade asset class, with poor liquidity and lots of volatility. Duda says this is an outdated view. The markets in these countries have evolved rapidly and are now much higher quality and very easy to access. But the misconceptions have left the asset class under-invested, meaning there are many more areas of opportunity.
Emerging markets also have much more policy flexibility than developed markets do, underscoring the attractiveness of the asset class, says Rick Harper. Unlike countries such as the US, emerging economies have spent the last few years paying down debt and getting their fiscal houses in order. They have been de-risking and are prepared for anything the global economy throws at them. Given the better fundamentals, the solid liquidity and maturation of the markets, the managers see opportunity in both local currency and dollar-denominated debt.
Bank Loans, Too
Bank loans are another area of the fixed-income market that investors are systematically underexposed to, says Kevin Petrovcik. Because bank loans are a private market and not securities, they aren't included in benchmarks and end up getting overlooked. Petrovcik thinks this is a mistake. These loans throw off decent yields while providing better protection than high-yield bonds because they are secured by the firm's underlying assets and are higher in the capital structure. Bank loans are also floating-rate, so investors gain some protection from rising rates.
Not-So-Hot Money
All three managers dismissed concerns that recent flows into these areas are hot money—they will retreat once traditional fixed-income assets look more attractive again. They said that the increasing interest is being driven by local demand in emerging markets and permanent changes to institutional allocations, not to trend-chasing.
No one saw increasing allocations to emerging markets and bank loans as a silver bullet to fixed-income investors' woes, but the panel clearly sees these non-traditional asset classes as a step up from accepting the negative real returns.
