The concept of diversification is probably among the first things wealth managers introduce to new clients. However, diversification for its own sake could leave a client’s portfolio skewed in unusual ways.
The UK’s most popular equity indices, the FTSE 100 and FTSE 250, are a great example. While the FTSE 100’s international pedigree is recognised, the latter is seen as a domestically oriented player. In reality, analysis suggests half its revenues come from overseas.
UK corporate bonds and their associated benchmarks follow this pattern; the sterling credit market offers the same global exposure as its equity equivalents. Only around 30% of the bonds which make up these indices are exposed to companies where earnings are largely UK based.
This makes some current trends rather surprising.
The first is the number of ‘investment tourists’ increasing their allocations to overseas corporate bonds at the expense of sterling holdings. Increasing costs from currency hedging aside, many of the bonds available in these new currencies already have a sterling based equivalent.
While the credit spreads available for bonds in other markets, such as the US, have previously been more favourable, recent moves have shifted to make sterling credit relatively attractive, such as in the bonds of large multinational companies like EON. Recent outperformance from its dollar denominated debt has made it less attractive.
While there are still sporadic opportunities in non-sterling markets for active investors, blindly buying overseas debt does not offer a panacea for those seeking greater returns and diversification.
The second trend is the shift towards passive mandates, a shift that makes the sterling market increasingly attractive for active investors. As corporate bond indices simply provide a hierarchical list of the most indebted companies, any move towards thoughtless capital allocation creates opportunities for those prepared to take a divergent view.
Rating agency methods, which generally assess default probability, not default impact, have exacerbated moves towards generic, unsecured debt. Regulations that push investors towards using ratings as a proxy for credit risk echo this.
Bonds such as highly covenanted, secured debt can offer relative value despite a low default impact. They are also typically issued under English law, making recovery of assets much smoother should a default occur.
Evidence of these bonds eroding portfolio value is scant, allowing active investors to create less benchmark dependent portfolios, without incrementally adding significant credit risk.
For investors seeking the tangible benefits diversification brings, actively searching closer to home might yield better results. As M&A increases and markets continue to accommodate debt with few covenants, investors should heed the philosophy of 'buyer beware'.
Portfolios offering effective seatbelts to protect against poor credit outcomes, such as strong covenants and security over assets will be key over the long term.
Shalin Shah runs the Royal London Asset Management Duration Hedged Credit fund alongside Paola Binns. Over the last three years the fund has returned 11.4% versus a peer average of 6.2%