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A break with tradition

Technical article

Publication date:

22 July 2021

Last updated:

18 December 2023

Author(s):

Tony Lawrence

Tradition dictates that fixed income portfolios are typically split between government and investment grade corporate bonds. In this article, we consider traditions and if they are there to be broken.

Tradition dictates that fixed income portfolios (a.k.a the ‘forty’ in the infamous 60/40 double act) are typically split between government and investment grade corporate bonds. Most of the time, the bond portion is implemented by buying huge passive products, predominantly focused on developed market issuers. These products are optimised for simplicity – they lend to a wide range of borrowers without reference to their credit worthiness or the level of interest they are paying.  

Right now, a staggering 25% of developed government bond issuance offers negative yields, requiring you to pay for the privilege of lending to them! And at the same time, large, stable companies have never offered you less compensation for the extra risk in lending to them instead. And in the traditional portfolios above, that’s what you end up buying. 

So why not break with tradition and think differently? Because although the large, simple fixed income products look extremely unattractive, if you broaden your horizons and do your homework, there are pockets of opportunity to be found.  

Take our position in the US residential mortgage space. US consumers have never had so much cash in their pocket or a house that’s worth so much. Combine this with mortgage rates at all-time lows, and you create the perfect backdrop for re-mortgage activity; people either want to stay where they are and pay less, or move onwards and upwards! So, we invest in the Angel Oaks Multi-Strategy Income Fund which directly benefits every time someone repays their mortgage, providing an extra 2% yield over what you receive when lending to a corporate. 

Being prepared to look outside of the main passive indices is crucial – we’re also lending to European banks. Regulators insist that banks issue special ‘additional tier one’ bonds, in order to protect the financial system. Because these bonds are a bit different, they aren’t eligible for the traditional indices, and because they are a little harder to analyse, a lot investors shy away. But we’re not afraid of the extra effort, and we like what we see; well-capitalised, low-risk national champion banks, paying 2% more on this debt than what their traditional bonds are paying. 

We haven’t stopped there – our final break with tradition has been to look outside of developed markets and venture east, finding a particularly attractive opportunity investing with UBS into Asian high yield corporate bonds. Once you’re over the geographic hurdle, you find that Asian companies, in the same industries and of equivalent credit quality to their US counterparts, offer 4% more per year on their debt – and in a faster growing economy. 

It turns out some traditions are there to be broken. 

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This document is believed to be accurate but is not intended as a basis of knowledge upon which advice can be given. Neither the author (personal or corporate), the CII group, local institute or Society, or any of the officers or employees of those organisations accept any responsibility for any loss occasioned to any person acting or refraining from action as a result of the data or opinions included in this material. Opinions expressed are those of the author or authors and not necessarily those of the CII group, local institutes, or Societies.