By Alex White, Managing Director, Co-Head of ALM at Redington
I tell you this asset class can solve all your problems, and it’s so good that it should make up your entire portfolio (excluding LDI).
You’d probably ask: ‘what characteristics does it have?’
And I’d say it has everything you could want:
• It has low returns
• It has no tail risk protection and can incur large losses in an extreme tail event
• It also has a simple and proven pricing indicator, which says now is one of the worst times to buy it in history
At this point you might be less than impressed, but what other characteristics does it have, and why should you buy it? Well:
• It has high emissions per pound invested
• It’s basically not diversifying
• It’s somewhat, but not hugely, liquid
• The track record shows nearly flat excess returns for fairly high levels of risk over the last three decades
• If DB schemes broadly do run into trouble, this asset class is likely to perform very poorly due to contagion
At this point, you’d probably kick me out. Most investors would not be interested. And it would be a very hard sell to replace your entire growth portfolio with this asset class. So, who would buy it?
Well, almost everyone - because I’m talking about Investment Grade Credit.
Now there are advantages to credit, but there is huge value in reframing decisions as a matter of course. Our brains did not evolve to make investment decisions, we are all susceptible to well-known biases, and this is a technique which can help with that.
So, to defenders of IG credit, I throw out two questions:
If it weren’t in your portfolio already, would you buy it now? This is a huge one, to tackle our natural tendency towards inertia.
My first challenge is simply to ask the question in a different way - not ‘should we reduce our IG holding?’, but ‘would we buy this from a blank sheet of paper?’
There are frictional costs, yes, and transactional costs are real. But they are much less impactful than SAA decisions, so if you get very different answers to the differently framed questions, it may be worth changing SAA.
The second question is in a similar vein - reframing a problem to mitigate universal human bias. Instead of asking ‘have spreads got so tight that we should change our SAA?’, we can ask:
At what level of spreads is it not worth holding IG anymore?
This framing has three advantages. It mitigates anchoring bias. It makes the decision less emotive. And it (somewhat ironically) encourages less binary decisions.
If I have any regular readers, they’ll know that I think IG credit spreads have tightened so far that even natural holders of corporate bonds should be seriously considering alternatives (I’ve outlined one of my personal favourites here ).
Maybe you disagree - there’s no single correct answer and any answer will depend on how other assets are priced plus the investor’s specific circumstances. But we probably agree on the extremes - if IG traded at a spread of one basis point, or even minus 100, I imagine we’d agree it wasn’t worth it.
And as we approach those bounds, we wouldn’t hold or sell the whole portfolio, but we’d reduce our allocation as we neared that level and increase it as we moved away from it.
We’re currently well into the lowest decile historically and I think that should motivate lower holdings.
Other advisors may disagree, which is healthy. Whatever answer you reach though, this framing still helps make it more academic and less emotive, which is generally a good thing for making financial decisions.
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