The interest rate outlook is less clear than it has been since the late 1970s. The U.S. Federal Reserve (Fed) raised rates in December 2015 but the timing and amount of future increases still is uncertain.
As rates move higher, low-yielding securities — those viewed by most investors as the “safest” since they are deemed the most likely to be repaid — still face interest rate risk, or the risk that higher future rates will reduce the value of lower-yielding securities. By contrast, the highest-yielding securities may present unacceptably high risk to some investors or, in some cases, may not be accessible to typical individual investors.
In this environment, it may be time to consider multi-asset funds, which can combine multiple asset classes and investment strategies within a single fund.
Impact of low rates
For many investors, the primary risk associated with fixed income investing has been credit risk, or the risk that the bond issuer will not be able to repay its debts. Yield levels are largely determined by the amount of credit risk a bond buyer is willing to assume. Lower-rated credits, such as junk bonds, pay higher yields because they are viewed as having more credit risk than higher-rated bonds, such as those issued by the U.S. Treasury.
In addition to credit risk, however, investors take on interest rate risk. Sensitivity to interest rate risk is measured as “duration,” which is based on yield and maturity. Lower duration equates to less vulnerability to rising rates while higher duration equates to greater vulnerability.
For more than 30 years, income investing strategies seemed relatively simple. With overall bond market yields trending gradually lower, investors became conditioned to believe that bonds would hold their value since the yields on similarly structured bonds issued in the months and years to come would be lower — and thus less attractive.
That ended when interest rates tumbled to historic lows as the Fed dropped its key short-term interest rate to zero in 2008. With the Fed pledging to hold rates low in a bid to stimulate the economy, many income investors responded by increasing allocations to higher-yielding junk bonds, accepting the increased potential risk in a bid for higher returns and yield.
Changing market leadership
Given the scope of recent market volatility, it can be easy to forget that markets have always been unpredictable. History shows that a mix of investments offers the potential to take advantage of return differences among asset classes and investment types. This diversified approach also can help protect an investor from extreme price swings in a single type of security. While diversification does not ensure a profit or protect against loss, it can help reduce the overall risk and volatility of a portfolio.
Multi-asset funds pursue such a diversified strategy through allocations to multiple asset classes in a single product. A review of annual performance over the past 20 years makes it clear that there is no discernible pattern regarding how individual asset classes perform — another indicator that favors a diversified investment approach.
In an effort to stabilize performance across market cycles, investors may seek to diversify in asset classes that are not closely related. One way to examine asset class relationships is through correlation, which is a statistical measure of how two securities move in relation to each other. A correlation of +1 implies the securities moved in lockstep through a specific time period. The chart below shows that stocks and investment grade bonds can exhibit low correlation. By contrast, high-yield bonds and stocks are more closely correlated.
One way to understand the potential of a multi-asset strategy versus a single-asset strategy might be to compare historical risk/return data of combined indexes. For example, based on five-year data, a combination of 50% high-yield bonds and 50% dividend-paying stocks offered a higher level of return than many fixed-income indexes, but with a lower level of volatility than dividend paying stocks alone.* A 50% blend of high-yield bonds and global bonds exhibited slightly lower returns and volatility. It is important to note that this is index performance and is not representative of the performance of a specific fund.
* As measured by standard deviation, a measure of the degree to which a fund’s or an index’s returns vary from its previous returns or from the average of all similar funds or indexes. The larger the standard deviation, the greater the likelihood (and risk) that a security’s performance will fluctuate from the average return.
Past performance is not a guarantee of future results.The opinions expressed are those of Ivy Distributors, Inc., and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through June 2016, are subject to change based on market conditions or other factors, and no forecasts can be guaranteed. The information is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance, and time horizon.
Investment return and principal value will fluctuate, and it is possible to lose money by investing. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Investment risks associated with investing in real estate securities, in addition to other risks, include rental income fluctuation, depreciation, property tax value changes and differences in real estate market values. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the Funds may fall as interest rates rise. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds.