In portfolios primarily allocated to government and corporate investment grade bonds, the familiar risk asset classes of equity, high yield and emerging market debt play indispensable roles by offering the potential for higher returns and diversification. However, we believe adding additional and less familiar varieties of risk assets may benefit investors. In particular, we believe that asset-backed securities and commercial real estate deserve consideration by investors seeking returns as well as protection from the volatility that will eventually return to financial markets.
Since the global financial crisis, investors’ ongoing search for yield in a low-rate world has spurred demand for these traditional assets, which has outpaced supply and driven their valuations up. Meanwhile, abundant liquidity from central banks’ quantitative easing policies has helped keep volatility far below historical average levels. We caution investors not to expect volatility to stay abnormally low, nor to lose sight of the importance of the underlying fundamentals of equities and high yield and emerging market debt.
A CHANGE IS GONNA COME
A look at those fundamentals reveals a mix of positive and negative characteristics that yield an investment view that is neither strongly positive nor strongly negative for these three risk asset categories taken together. For high yield, default expectations have declined since mid-2016, which is a positive development. Meanwhile, however, a rising dollar and the likelihood of increased trade tensions with the U.S. are creating headwinds for some emerging markets.
Despite their mixed fundamentals, valuations for the three asset classes have grown richer since the beginning of last year. While returns have been strong, investors are now receiving less compensation for owning these assets than they did a year ago. Valuations, either for industries or regions, appear only fair given the strong performance in spreads for most bond categories since the U.S. election. Only emerging market spreads have widened since the election, reflecting market concerns about potential shifts in the direction of U.S. trade, fiscal and monetary policy. Although some money has been flowing out of emerging markets, flows into equities and high-yield bonds remain positive and we believe this may remain the case for as long as another 6-12 months.
Investors, though, cannot chase yield rather than focusing on fundamentals forever and eventually the technical factors that have been driving markets will reverse, large quantities of securities will need to be unwound and spreads will widen. Investors who want to mitigate the volatility that will accompany this shift in the markets without prematurely reducing their exposure to risk assets and forsaking yield should consider diversifying beyond the three familiar categories.
ALTERNATIVES TO THE BIG THREE
The return and diversification benefits of equities, high yield and emerging market debt may also be found in lesser-known varieties of risk assets, including lower-quality auto assetbacked securities (ABS) and commercial real estate. Both not only have low correlations to the Bloomberg Barclays U.S. Aggregate Bond Index, but also to traditional risk asset classes. Commercial real estate is even negatively correlated to high yield and emerging market debt. While returns in these sectors are not necessarily higher than those of more traditional risk assets, we believe they offer lower overall volatility.
ABS, as their name suggests, are securities backed by underlying collateral ranging from auto loans to credit card receivables to student loans. This asset class may carry a negative connotation for investors who remember the home equity fiasco that contributed to the global financial crisis. Today’s ABS market is no longer focused on home equity, however. Instead, more than half of the bonds issued are backed by auto loans and leases and this is where we believe value exists for investors.
Auto-backed securities have multiple rating classes and typically short maturities of four years or less. This gives each investor the opportunity to allocate based on their acceptable risk and yield targets. In particular, we see value in the BBB- and BB- rated classes of ABS securities, especially when compared with spread levels for BBB and BB corporate bonds. Not only do their valuations appear attractive, the fundamentals and natural deleveraging of the sector are also appealing as the credit enhancement built into each deal is created with the expectation that it will grow over time.
COMMERCIAL REAL ESTATE (CRE)
Despite capitalization rates having reached cyclical lows, commercial real estate continues to have value both from a fundamental and valuation standpoint. CMBS issuance is well below where it was prior to the financial crisis and we expect new regulations to further limit issuance from traditional lenders and asset managers and the private market to fill the gaps in funding. Residential construction other than apartment buildings has remained relatively subdued and demand continues for retail, industrial and office space, suggesting that real estate valuations remain attractive. Given its negative correlations to other risk asset classes, allocating a portion of one’s risk budget to CRE may help an investor achieve their target returns even when demand for equities and high yield bonds begins to wane.
By adding allocations to these unfamiliar but potentially worthwhile securities, we believe investors may be able to continue enjoying the benefits of risk assets while worrying less about what happens when equities, emerging markets and high yield inevitably fall out of favor and volatility rises.