Global investment manager Schroders has warned that the dearth of returns on cash and fixed income will continue into 2021, with a trip down the capital structure or a venture into private debt being the most likely alternatives to allocating more capital in equities or riding out the low-rate wave.
Schroders’ head of fixed income and multi-asset, Simon Doyle told media this morning that while interest rates remain anchored low returns from traditional defensive assets will continue into 2021. For investors and their advisers, the outlook isn’t encouraging.
“Low rates have directly and indirectly dragged down yields across the interest rate and credit curves,” Doyle said. “We can say with a high degree of confidence that returns from cash and fixed income investments, particularly at the lower risk end of the spectrum will in absolute terms be lousy in 2021.”
While investors often weigh up the prospect of meagre defensive returns against a higher allocation to equities, Doyle believes the options between those two extremes – what he calls “the big middle” – offer a alternative path.
“Fixed income is actually a broad set of opportunities that traverses the whole debt spectrum,” he said. “There’s a very big universe to draw on.”
That universe incorporates all grades of corporate and government debt, he explained.
“It is important that investors use the full capital structure and in particular consider the use of higher risk defensive assets which offer better returns than cash and low yielding sovereign bonds without assuming all the risk of equities,” he advised. “In this environment, defensive currencies and options to mitigate downside risks will also be an important part of portfolio management.”
The challenge at the moment is that nothing is going to give you eight to 10 per cent without taking a huge amount of risk, he said. Investors can increase returns and only take on measured amounts of extra risk if they’re open to “slipping” down the capital structure and taking on mezzanine debt of preferred equity.
“Higher yielding credit can mean simply taking a step down the capital structure,” he said. “It can mean more subordination [because] you’re further back in the queue, but it can generate increased income for investors.”
The risk premium comes with a cost beyond the risk itself, he notes, as investors will need to lock their investment in for some time. “These aren’t liquid markets… but investors with some sort of time horizon to their investments can provide capital there and earn a risk premium,” he added.
“There’s no silver bullet but I think there are alternatives that sit somewhere between the very high quality cash government bond and equities,” Doyle said. “That big middle as you step down the capital structure and or into private market solutions are definitely worth looking at.”
Caveat emptor
While defensive currencies and strategies to mitigate downside risk will be an important component of portfolio management in 2021, Doyle points out that continued volatility should also be expected. Going off-piste isn’t always for the faint-hearted.
“Volatility will be at the forefront again in 2021, particularly in the coming weeks due to the political instability in the US and the global COVID-19 vaccine roll-out,” he stated.
This can be a positive for investors as it could present solid opportunities for active asset allocation reminiscent of the volatility seen in February/March 2020. But if the pendulum swings back towards a recovery the possibility of increased inflation will need to be accounted for.
“Investors need to keep a close eye on inflation,” Doyle said. “While excess capacity in financial markets and the labour market created through the COVID-19 recession will keep a lid on inflation as the recovery takes hold in 2021, the extent to which policy settings are aimed at generating inflation could increase the risk of inflation rising above recent norms in the medium term.
“This could lead to pressure on bond yields and policy support mechanisms over the medium term, which could threaten the cocktail of support that markets have grown to love and rely on. This would be a catalyst for more structural difficulty for markets.”
