Bonds 7 minutes to read

Why it's time for equity bulls to diversify

Althea Spinozzi

Fixed Income Specialist

Summary:  Equity-only portfolios have enjoyed an unprecedented run, but as more and more indicators warn of an incoming recession, it's time for investors to look at fixed income.


Since the financial crisis and until very recently, there has been no reason for equity investors to diversify their portfolios with other instruments. The bull market, after all, meant continual low volatility and high returns. The side effects of this protracted bull market, however, have started to become more apparent.

An increasingly over-leveraged financial system, combined with slower growth and political uncertainty, is making it more difficult for investors to navigate turbulent markets.

Until a year ago, bonds were broadly out of favour as years of easy money in the US and in Europe meant that the yields offered by corporate and government bonds were quite low. As well, the threat of increasing inflation led many to believe that it could potentially erode the greater part of the real yield.

We now find ourselves in a different situation. Last year, the Federal Reserve started to hike interest rates in the US, pushing yields higher; at the same time, inflation seemed to stand still, suggesting that a short-term bond portfolio would be able to beat inflation.

Central banks have now made a further U-turn towards dovish, bond-supportive policies. Meanwhile, the equity market remains far too expensive as major economic indicators (such as an inverted yield curve) signal that a recession is about to start.

Fixed income investing is certainly a challenge, but a turning market will make it a necessity for many equity-only portfolios

As such, equity traders now need to diversify their investments and look at bonds. While holding bonds can potentially leave one unable to invest in more lucrative opportunities, the likelihood of a coming recession means this could actually be a positive for fixed income. After all, investing in a bond guarantees a certain return (yield) to the holder even if riskier assets endure significant repricing.

But which bonds?

The best choice would be to decrease volatility by investing in bonds that have a low correlation to stock markets. Government and investment grade bonds serve this purpose well, while high-yield and emerging market bonds are perceived as risky and could suffer ratings downgrades and defaults in the event of a broad sell-off.

Fixed income might be a traditional safe haven, but one still needs to stay cautious. Yield is certainly an important factor, but yields could spike after years of record low default rates as recession draws closer. This is why it is not advisable to select bonds from the lower HY space or from highly leveraged companies. The safest way to prevent defaults is to remain in the investment grade space; even though these names are not invulnerable (highlighting the importance of a solid balance sheet), IG firms still hold a far lower default risk than do HY corporates.

The good news is that, in the USD space at least, it remains possible to find solid IG names offering a pick-up between 100 and 150 basis points over Treasuries. This means it’s possible to lock in a yield of approximately 4% in the IG space – even for maturities of five years or less.

Investors should be aware that even IG spreads will widen along with HY spreads as recession approaches. Considering that historical data show that recession can occur within 24 months of yield curve inversion, however, investors still have plenty of time to select only the names and maturities they truly like, taking advantage of widening credit spreads.

In our view, this is where financials shine, with names like Barclays, Unicredit and Intesa San Paolo offering a little over 4% for maturities up to five years. Unicredit with maturity January 2022 (XS1935310166) is offering 4.5% in yield for a maturity of two-and-a-half years while Intesa with maturity January 2024 (US46115HAP29) offers 4.5%. At Barclay’s, one would need to take a longer maturity in order to pick up a similar yield, for example the March 2025 (US06738EAE59) issue. 

Beyond financials, we see solid opportunities in other sectors such as food and beverages, where Kraft Heinz with maturity February 2025 (USU42314AA95) offers a yield of 4%. For more speculative investors, car manufacturers may be attractive with Ford’s May 23 maturity (US345397XZ10) offering a yield of 4.8%.

It will not come as a surprise that bonds are more expensive in the euro area. The pickup versus German bunds is quite good, but if investors have a cost of funding different from the bund (such as Spanish Bonos or Italian BTPs), credit spreads are much tighter. If investors are yield-driven, they will need to compromise on credit quality and look to pick up names in the lower IG ratings class, risking credit downgrades that could push these bonds into HY territory. Here we can again point to Ford, where a March 2024 maturity (XS1959498160) offers a 2.8% yield.

To find an interesting pick-up in the EUR IG space, investors would need to look at longer maturities to find better-rated corporates offering 2%-plus in yield, such as Volkswagen with maturity June 2027 (XS1586555945).

Fixed income investing is certainly a challenge, but a turning market will make it a necessity for many equity-only portfolios. Our recommendation is to explore the space and selectively pick up bonds that could serve as buffers during a downturn. While parking cash in sovereigns may seem the most obvious choice, high-quality corporates may provide similar stability with extra pick-up.

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/legal/disclaimer/saxo-disclaimer)

Saxo Bank A/S (Headquarters)
Philip Heymans Alle 15
2900
Hellerup
Denmark

International

Trade responsibly
All trading carries risk. To help you understand the risks involved we have put together a series of Key Information Documents (KIDs) highlighting the risks and rewards related to each product. Read more

This website can be accessed worldwide however the information on the website is related to Saxo Bank A/S and is not specific to any entity of Saxo Bank Group. All clients will directly engage with Saxo Bank A/S and all client agreements will be entered into with Saxo Bank A/S and thus governed by Danish Law.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the U.S. and other countries. App Store is a service mark of Apple Inc.