Against a backdrop of improving global economics, the world's monetary authorities are expected to t...
Against a backdrop of improving global economics, the world's monetary authorities are expected to tighten policy in the near future. While interest rates remain close to historic lows, they appear to have bottomed out in the present cycle and the next most likely direction will be upwards.
In this environment, where should the shrewd investor be putting their money?
Conventional wisdom says that at this stage of the economic cycle, with activity expanding and interest rates looking set to rise, investors should be avoiding bonds and putting their money into equities. But is this correct this time around?
First, should investors be buying equities? As interest rates have fallen, equity markets have enjoyed such a significant re-rating they are likely to suffer a de-rating should interest rate levels rise again, particularly in light of the fact valuations already appear stretched.
We have already begun to see evidence that this is happening, with equity markets having suffered this year in spite of the improving underlying economy. So, perhaps now is not the best time to buy equities.
Second, should investors be avoiding bonds? Well, government and investment-grade bond markets have already priced in rises in short-term rates.
However, they are still likely to struggle as longer rates rarely come down as short rates rise. In addition, they do not offer an attractive return at present so investors may be right to avoid bonds.
But not all bonds. What about high yield?
High yield is significantly less exposed to interest rate rises, with a greater proportion of the overall yield represented by company-specific credit risk.
Therefore, the improving corporate backdrop, leading to a reduction in default rates, more than compensates for rises in interest rates. In addition, much higher yields are available in this market from the outset.
So, high yield could perhaps be the best-performing asset class this year as well as the solution to the problem investors face as to where to put their money.
The fact high yield can perform differently from other types of bonds as well as equities demonstrates another reason investors should look to high yield as an asset class.
This lack of correlation with either equity or other bond asset classes means high yield is a diversifier and therefore has a place in every portfolio in order to help reduce overall volatility.
So what are the risks? Well, if economic conditions start to deteriorate, it could create credit concerns, which would be bad for the high-yield markets. Of course, equities are also likely to suffer in such an environment.
High yield definitely merits attention. It would certainly help diversify overall portfolio risk and, in an environment of rising interest rates, it may even prove to be the best-performing asset class.
Attractive yields already available.
Much less exposure to interest rate rises.
May be best-performing asset class this year.