The risk of structurally higher inflation should prompt DC plans to consider liquid alternative credit strategies
Investors experienced two straight years of losses in their traditional bond portfolios in 2021 and 2022 – the first back-to-back negative returns since 1997/1998. This was triggered by central banks responding to persistently elevated inflation with an aggressive rate-hiking cycle.
In 2024, market consensus has been – and continues to be – that interest rates will eventually head lower thanks in large part to moderating inflation. However, recent economic data has prompted market participants to push back expectations for when the initial policy action will start. Central banks have made good headway chipping away at inflation levels, but their job’s not yet done.
The debate over whether the so-called four Ds (debt, demographics, deglobalization, and decarbonization) have elevated the long-term structural level of inflation rages on. Worse still would be permanently higher inflation and slowing growth, a toxic combination called stagflation. In Canada’s case, productivity gains have been mediocre for decades with little evidence of a pickup. Volatility and uncertainties abound.
What should investors make of these risks? Is there a strategy that can potentially cope in a world where these scenarios play out but also thrive if they do not come to pass?
Amid this uncertainty – and fresh off a multi-year drawdown in traditional fixed income – we think investors should consider alternative approaches to managing their fixed-income allocations,particularly strategies that aren’t predicated on sacrificing liquidity to generate attractive returns where possible.
One potential solution is a strategic allocation to an unconstrained global credit strategy. These types of strategies offer the potential for attractive risk-adjusted returns through dynamic management of credit and interest rate risks throughout the investment cycle, including inflationary periods.
There are many different flavours of unconstrained credit strategies, but the common ingredients include a broad corporate investment universe, a dynamic investment approach, an absolute return focus, and an enhanced awareness of risk.
A sample of the breadth of credit securities includes investment-grade corporates, high yield, loans, securitizations, and emerging market bonds.
Active managers know that credit spreads can stay tight, and yields can stay low, for long periods. Shifting to higher credit quality and shorter duration mitigates risk in expensive markets. When markets are cheap or distressed, a dynamic approach calls for taking advantage of the opportunity by rapidly and decisively shifting into lower credit quality positions.
Arguably, credit exposure must be actively managed as there are times when spreads rapidly increase (e.g., the Great Financial Crisis of 2008 and COVID-19 in March 2020). These periods lead to substantial short-term volatility but offer the potential to reap significant long-term profits, rewarding investors who dynamically increase exposure and risk after credit sell-offs and patiently hold on during the recovery phase of the cycle.
Absolute return focus is defined as the goal of generating positive returns regardless of market environment, independent of a benchmark return. Free from the typical constraints of a benchmark-relative mandate, an unconstrained strategy has the license to capitalize on market dislocations whenever and wherever they occur.
Traditional funds “constrain” risk by mandating adherence to a benchmark. These constraints target tight tracking error but often increase risk with poor outcomes. It is not always an effective way to manage downside risk. Unconstrained credit strategies can be selective about when and how much risk to take on and can avoid certain risks entirely if the compensation is deemed insufficient. Many traditional fixed-income strategies do not have this flexibility.
Unconstrained credit offers a suite of attractive characteristics for DC plans. Their flexible duration mandates allow the manager to sidestep drawdowns from sharply rising bond yields. Their higher return targets can help plan members without a meaningful change in total risk. They offer a liquid investment profile and a well-diversified mix of credit sector exposure that a lot of DC plan members tend to have less exposure to.
Regardless how the inflation debate plays out, unconstrained global credit is likely an under-allocated but useful component of a well-structured portfolio.
Disclaimer
This publication and its contents are for informational purposes only. Any views expressed in this publication were prepared based upon the information available at the time and are subject to change and possible correction. In no event shall Mawer Investment Management Ltd. (“Mawer”) be liable for any damages arising out of, or in any way connected with, the use or inability to use this publication appropriately.
Kevin Minas is an institutional portfolio manager at Mawer Investment Management, one of Canada’s largest independent asset managers.
