Spare a thought for the fixed-interest investor. When they invest in a bond, the best they can really hope for is to get regular income payments, and then their money back. At worst, they can lose the lot.
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In investment speak, this is called an asymmetric payoff: the potential downside more than outweighs the potential upside.
This contrasts with equity investors, who likewise can lose the lot if things go really wrong, but whose upside is theoretically unlimited.
And so it’s hardly surprising that fixed-income managers view the world quite differently from equity managers. It is perhaps summarised by the statement that fixed-income investors focus on what could go wrong; equity investors focus on what could go right.
Another issue that differentiates the two world views is that diversification plays a much bigger role in fixed-income investing.
When you have 100 per cent of your capital at stake in a particular fixed-income security, and virtually no chance of increasing your capital (assuming it’s held to maturity), you’re naturally more risk averse than someone who might have 100 per cent of their capital at risk in a particular stock, but who might also hold another stock that could increase significantly in value.
Jeff Brunton, AMP Capital’s head of credit markets, says diversification of a bond portfolio is therefore even more important than an equity portfolio.
“The key difference is that the return pay-offs for bonds are just so asymmetric. We buy a bond at $100 and par, and the best thing that can happen to us is the bond pays our coupons when due and then we get the $100 back at the end, at the maturity of the bonds.
That is the best thing – that’s the upside. The downside is the bond defaults, and we get nothing back.”
Underweight bonds?
Cliff Asness, the founding and managing partner of AQR Capital Management, says investors need to pay more attention to where risk resides in their portfolios.
Asness says that, put simply, if capital is allocated 60/40 between equities and bonds – not an unusual asset allocation – then many investors will consider it to be balanced.
But if the risk of the portfolio is analysed, it will be seen that the risk associated with equities completely swamps the risk associated with bonds. AQR’s research suggests that a portfolio allocated by risk, rather than by capital, can produce better long-term, risk-adjusted returns.
A typical portfolio has an over-reliance on equities – which is another way of saying it is underexposed to other asset classes – and as a result is exposed to a disproportionate amount of risk. Equities are something like four times more risky than bonds.
“If you think that risk is justified, you have to believe the risk-adjusted return from equities will be eight or nine times that of bonds,” Asness told the AQR University in Melbourne last month.
AQR’s latest research suggests that both bonds and equities currently are overvalued, and that an equal allocation of risk to bonds, equities and commodities will provide a superior risk-adjusted return over the long term.
