J Stern & Co multi-asset income manager Jean-Yves Chereau has described the “new normal” high yield, high rate environment as a “game changer” for the income investing landscape.
“The world has totally changed,” he told Portfolio Adviser. “For the past three years, with interests rates close to 0%, investors have had to take on more risk to get a return. Hence, people have been buying equities.
“If you were investing in high-quality corporate bonds, you were making 0% or close to that. The alternative was high yield, which involved taking more risk and then the next alternative was equities, which involved taking on even more risk.”
Rapid interest rate hikes from central banks around the world over the last 18 months have caused multi-asset managers to revisit their fixed income allocation.
Chereau, who manages J Stern’s Star Multi-Asset Income Fund, said: “I’m currently buying three-month US Treasuries with a yield of more than 5%. We are buying investment grade [bonds], which are more attractive, but still not fully attractive, with an expected total return or yield to maturity at around 4.5%. For emerging market debt, we are talking of 8%+ current yield and around 11-12% yield to maturity, or total expected return per annum, for a period of four years. So, it really is a game changer.”
He added: “Today, you can make a 4.5% return by taking zero risk. That is a game changer. Following this year’s stronger-than-expected relative performance of our equity portfolio, we have further reduced our equity exposure from 35% to 30% and are reinvesting the cash in a combination of credit and short-dated US Treasuries. With very short-term US Treasuries now yielding around 5.4%, cash is ‘king’ again for the moment.”
Income investing entering a ‘new normal’
The fund is a second-quartile performer in the mixed asset sector for the year to date, returning 1.55%, according to FE Fundinfo.
Its approach is to allocate between 25-45% of its portfolio to equities at any one time to drive capital growth. Its credit portion can make up anywhere between 35% and 55% of the portfolio in order to generate income, while non-correlated alternatives make up the rest.
Chereau said that while over the last few years he has allocated more aggressively toward equity, the fund has trimmed its allocation to around 30% from over 40% at the beginning of the year.
From a credit perspective, the fund’s allocation has hit the 50% mark towards fixed income.
See also: Bank of England’s ‘war on enemy number one’ continues with 14th hike
Chereau believes interest rates will stay higher for longer in both the UK and US and therefore the fixed income sector could be entering a “new normal” after a decade of near-zero rates.
He said: “Our central scenario at the moment is that we should have a soft landing. So, a scenario where you would see interest rates being cut very aggressively down is only a scenario where you would see an economy tanking. What’s priced into the markets at the moment is up to six 25bps interest rate cuts [in the US] next year, so therefore, the short-term yield would come down.
“The 10-year Treasury yield may actually stay exactly where it is. What is interesting is the fact that before, investment grade bonds were yielding 2.5%. The reason they were so low is because those have been issued during those years, but whatever people do now coming into the market, they will have to issue a much higher rate.
“So, maybe in six months or 12 months’ time, I will not be able to buy very short-term US treasury yield at 5%. That’s pretty much certain. But I could replace those with investment grade bonds, which are probably going to be between 4% and 5%.”
Since Chereau spoke to Portfolio Adviser, the US government had its credit rating downgraded by ratings agency Fitch.
Reacting to the news, Chereau said it did not change his outlook for US Treasuries, as the downgrade is more about perception and the US is very unlikely to default.
He added: “[The downgrade] gives investors a better entry point. Because of the knee jerk reaction yesterday, I’m using the opportunity to buy more for some clients.”
See also: Investor reaction: US credit downgrade ‘purely political’
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