Diversification could be more difficult to achieve, however, as equity bond correlation tends to rise in more inflationary environments.
Adding flexibility and shortening duration in fixed income
Traditionally, government bonds have been seen as an important source of income for portfolios, but also of diversification against equity exposures – as in the classic 60/40 allocation.
An environment of structurally higher inflation and heightened market volatility makes it more likely that government bond yields could rise at the same time as equity markets decline, however, as we saw in the first half of 2022.
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A broader, more flexible approach to fixed income allocations, which enables investment and rotation across the widest range of fixed income markets – from ordinary investment grade and high yield corporate bonds to loans, securitised credit, emerging markets debt, mortgages, corporate hybrid securities, semi-liquid credit markets and beyond – could deliver higher overall yield than government bonds with less exposure to rising interest rates.
Short-duration credit, in particular, can offer investors the advantage of less exposure to volatile interest rates while giving up very little yield relative to longer-dated bonds.
Exposure to credit risk is likely to come with some correlation with equity markets, but the more diversified the fixed income portfolio, the lower that correlation is likely to be.
Seeking out uncorrelated markets and strategies
Some market risks are entirely different from the economic risks of equities and bonds, such as those associated with catastrophe bonds and other insurance-linked securities, whose cash flows and pricing respond to events such as earthquakes and hurricanes.
Low correlation can also potentially be achieved with relative-value and market-neutral hedge funds; or with short- and medium-term trading strategies.
Prioritising inflation-sensitive real and financial assets
Inflation-sensitive real assets classes include commodities, real estate and infrastructure. As we have seen in 2022, rising prices in raw materials often drive spikes in broader consumer-price inflation, while over the longer term, the decarbonisation of the economy is likely to increase demand for many commodities, especially metals.
In real estate, as construction costs rise, the value of existing real assets also tends to rise; many sectors have longer-term leases with contractual inflation-linked escalators, while others have annually renewable leases, whose rents rise and fall with consumer prices and wages.
Similarly, in infrastructure, long-term usage contracts often adjust in line with a producer or consumer price index or, in the case of a utility, the price of its commodity feedstock; other assets are often critical enough to have considerable pricing power.
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Among financial assets, treasury inflation protected securities (TIPS) and other index-linked bonds, especially those with short maturities, are one of the few bond markets where total returns can match severe spikes in inflation.
Real yields have risen rapidly this year, creating more attractive entry points in some markets.
And in equity markets, some stocks are more “real” than others: commodity producers, real-asset owners, semiconductor manufacturers, banks and capital goods manufacturers generally find it easier to pass on their costs than “downstream” business, such as retailers.
Identifying and hedging against the tail risks that matter to you
It is often prohibitively expensive to implement hedges against general market tail risk (such as buying equity index put options).
It can be more cost-effective to identify the specific tail events that most concern you, or to which you are particularly exposed due to the nature of your liabilities or investment programme, and work with a trusted partner to analyse and design tailored hedging solutions for them.
Niall O’Sullivan is chief investment officer, multi-asset strategies, EMEA at Neuberger Berman
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