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Where to find value in a multi-asset portfolio

Introduction: Johanna Kyrklund is Group Chief Investment Officer (CIO) and Global Head of Multi-Asset Investments at Schroders.

Kyrklund was recently interviewed by Morningstar's Chief Research and Investment Officer Dan Kemp for the digital day of the Morningstar Investment Conference. The following is an edited extract from that interview.

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Dan Kemp: Bonds have had a tough couple of years having had a really good period for a long time. So how are Schroders thinking about not just what bonds are going to do, but their role in a multi-asset portfolio? I think that's what people are struggling with.

Johanna Kyrklund: Well, this comes back to the benefit of having some kind of strategic roadmap on a one to three-year time horizon. We came to the conclusion that we were going to see a deterioration, that rates weren't going back to where they were before, and that bonds therefore are not going to be offering that negative correlation with equities. That's been our core view.

And I think it's been very interesting. If you think about it, just over the last two years, you've had three attempts by the market to price in a major Fed pivot. Three times they've tried it. I think that's the market participants getting used to the fact that we are in a new regime. But it takes a very long time.

We had a generation, particularly of bond investors who – if you were a bond bear, I don't think you survived the last 15 years, right? You wouldn't be employed anymore. So, in some senses, we have bond investors biased to wanting to buy their market, always worried that they might miss out. There's a bit of FOMO in bonds. And generally, also for allocators hooked on that negative correlation between bonds and equities, attempting to pile in and constantly positioning for a bond bull market.

We have said constantly that there is a role for fixed income, but it's as a source of yield rather than a source of diversification. So that means that you need to recalibrate the yields at which you will buy it. When it was highly diversified, you could buy at very low yields. But actually, in an environment where you can't rely on that negative correlation, it's there to generate income. Of course this is the old-fashioned reason people used to own bonds, and there's actually nothing wrong with that. There's a case for them, but you just need to recalibrate the yields. Again, that strategic mindset has helped us.

While I'm on this, there is a debate out there that says 60/40 is dead because bonds are no longer negatively correlated with equities. I would say that I don't think that's right, because when 60/40 was first invented decades ago, you had a positive correlation between bonds and equities. Bonds were owned for income; equities were owned for growth. The negative correlation was something that came in the last 15 years. It was not the original premise for that model.

Kemp: I think that's absolutely right. At the same time, where that negative correlation tends to let you down is when you've had rising real yields. That's been where the bonds haven't really provided that hedge, and real yields are a lot higher than they were. So that's a much better starting point.

Kyrklund: I'd much rather have a yield on bonds than be where we were before with 0.6% on the US Treasury. And then there's a role for commodity-related investments. So, the other side of this equation is, if you're worried about more geopolitically tense environment in a world where commodity supplies are disrupted by the path to decarbonisation, because it's skewing investment patterns, there's a role for commodities in the portfolio that you didn't have in the last decade. So, generally, we've also been favouring commodity-related investments for diversification now, which of course is good for Australia.

Kemp: Absolutely. I'm fascinated by that because when we think about the role of commodities, we can think about it as a hedge for demand, there's some inflationary hedge. But how do you think about the forecasting of the returns of commodities compared to bonds and equities? And again, going back to your earlier comments about getting really deep into individual asset classes, how do you bring commodities into the equation?

Kyrklund: Over the long term, commodities don't have a risk premium. So, it does come to the real yield. Ideally, you want to have a positive real yield if you're buying commodities. That's step one. I generally don't like a negative carry situation if I can avoid it. And interestingly, of course, US Treasuries are still negative carry versus cash. But anyway, that's another story. Generally, we tend to favour physical commodities when we can get a positive real yield. That's where we tend to think about it, and when we can see an environment where they offer diversification.

So in the 2010s, the main issue [was] we were in a deflationary environment where commodities were not diversified because we kept getting growth shocks and our equities would fall and commodities would fall at the same time. But that's why generally they're making it into our portfolio more. We can't do it based on traditional valuation because there isn't a risk premium. But if you get a positive real yield and it's diversifying, then it typically earns its place. And we don't necessarily do it just through physical commodities. It might be through the stocks as well or the currencies.

Kemp: Just in case people aren't familiar firstly with the idea of carry investments - can you unpick that a little bit for us?

Kyrklund: Positive carry is when you're earning a return over cash.

Kemp: So you can borrow in cash, then invest and you get a positive return on that.

Kyrklund: Yes. Exactly. And if you have a negative real yield in commodities, it means your starting point is you're losing money. And right now, because the shape of the yield curve in the United States, if nothing happens, you're losing money versus cash if you're in the US 10-year. You actually need rate cut expectations to come in to move that.

Kemp: And that's because shorter-term rates are higher than longer-term rates.

Kyrklund: Yes. Thank you. I should nick that explanation. But I always think you want to stack the odds in your favour. You typically want to try and own stuff that gives you a positive yield. Generally, that's a good idea.

Kemp: Yeah. And the really interesting thing there is that often people underestimate the benefit of that positive carry, that kind of keep accumulating over time.

Kyrklund: Yes, the compounding of return.

Kemp: Exactly right. So, let's talk about credit because, again, typically a positive carry type investment, we're seeing spreads quite narrow at the moment. How are you thinking about that?

Kyrklund: Again, in the context of owning fixed income for yield, generally we'll own fixed income if it gives us a return above cash, we have been favouring credit over the last couple of years. Things are getting a little bit more challenging in some markets, particularly US investment grade debt because the US investment grade curve is actually inverted now. So, you don't earn a premium over cash in the US anymore.

Kemp: Yes. So even when you're lending money to companies rather than government, you're still not getting that positive carry.

Kyrklund: Yes. That, I would say, is starting to look a bit expensive now. And, we're steering away from that. The corporate fundamentals are still strong. But ultimately, that's why we favour equities to generate return right now is because we're not getting necessarily the same payoff that we were getting before in credit. But we still like investment grade debt, for example, in Europe.

Kemp: Interesting. Is that more of an interest rate view? Is it more of a corporate fundamental view or this value spreads?

Kyrklund: Yeah, positive yield over cash. And then as an index, [it's] pretty high quality.

Kemp: You mentioned commodities. You mentioned not using bonds so much for diversification. Do you have other things in the portfolio that you're looking to diversify the equity exposure?

Kyrklund: For a long time, everybody had [interest] rates at zero, which made it very difficult to see divergence between different economies. I think now we're in an environment of a much greater divergence. That's creating opportunities across different equity markets. This is where – as I said, we put this thesis together a couple of years ago, a number of things have played out. The one that hasn't played out was the ongoing outperformance of the US, because I would have expected that potentially with a higher rate environment, some of the more value-oriented markets would have been outperforming the United States. The Magnificent Seven came in and essentially overwhelmed that. The Magnificent Seven have been so cash generative, they're in some sense almost cash plays because they're probably earning a return on cash. That's been the big surprise. But if you look under the surface of the US market, what you find is the broader market has underperformed quite significantly. Actually, its performance has been much more similar to markets outside the US. But I would expect more opportunities in value generally.

Johanna Kyrklund is Group Chief Investment Officer (CIO) and Global Head of Multi-Asset Investments at Schroders.

3 Comments
Steve
May 24, 2024

The problem is bonds are not all the same. Floating rate bons have much less capital risk but still decent income. Fixed rate bonds are the source of recent issues, and some distinction needs to be made.

Warren Bird
May 25, 2024

There are a lot more nuances than just the floating vs fixed distinction. There is in reality a matrix of security types that fall into the broad category often called "bonds".

Normally in professional circles, floating rate securities - in which the regular interest payments are calculated as a fixed margin over a short term interest rate that's probably going to be different from payment to payment - are not thought of as bonds. Fixed rate securities are bonds.

But it's not that simple because there's a category of floating rate assets that are called bonds. This is when the ever-changing component is the CPI and they're known as Inflation-linked bonds.

Add in the range of issuer credit quality, including high yield (sometimes aka junk bonds), and alternative structures where the securities might be called by the issuer before the legal maturity date (typically issued for 10 years but callable after 5) and the matrix becomes multidimensional.

Still, when I use the word "bonds" I typically have in mind only fixed rate, fixed maturity securities. Doesn't mean they're "all the same" (to use Steve's expression) but the differences are more about the issuer and term to maturity than structural things that can affect how much each interest payment will be. With bonds you know the cash flows you've been promised. All the others have variability to the cash flows. That creates different risks and opportunities that can be weighed up in building an income-focussed portfolio.

Ray N
May 23, 2024

Great insights, especially about bonds being for income more than diversification.

 

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