Asset allocation: greater risks will have to be taken to target the same return!

The central banks’ policies have driven risk-free interest rates down so low that the benefits of holding sovereign bonds in a portfolio – their return and the protection they provide – have essentially vanished.

Investors need to rethink their allocations given that these assets no longer pay interest. Greater risks will now have to be taken to target the same return.

The financial repression continues…

Gianluca Tarolli, Chief Economist and Strategist, co-CIO

To meet investors’ goals, which vary according to their needs and constraints, a diversified portfolio can be built using assets that all serve a different purpose. The three main ones are 1) protection, 2) income generation and 3) capital gains. In the past, long-dated sovereign bonds, gold, and ‘haven’ currencies such as CHF were considered protective assets. Corporate bonds used to be seen as the income-generating assets par excellence. Listed equities were regarded as the primary source of capital gains.

It’s still too early to suggest that Chinese sovereign bonds will oust us treasuries as a source of protection, but we truly believe they represent an appealing alternative source of yield.

Risk profiles (CHF): critical for achieving targets

The major asset-allocation challenge over the next few years will be to maintain an unchanged level of income while keeping the lid on any increase in risk – a factor which is now especially crucial for achieving this objective.

The starting point for risk-free interest-rates is so low in USD – and indeed negative in CHF and EUR – that the role of government bonds has changed. Not only do these bonds no longer produce any income streams; but crucially, they do not provide any protection when risk aversion increases. Conversely, if – as we think – interest rates were to pick up in 2022, even just modestly, longer maturities would be bound to suffer capital losses.

To find alternative sources of protection, compromises must be accepted. Though volatile, gold is a prime alternative that performs well when investors lose their appetite for risk. Options (derivatives) provide a form of insurance, but a premium has to be paid. This highly effective but expensive solution can be implemented systematically via structured products. Lastly, conservative strategies fulfilling this protective role can also be found in the hedge fund universe.

Switzerland: sovereign bonds no longer supply protection in equity bear markets

Looking ahead to 2022, we believe high-yield corporate bonds will be an attractive source of income, along with Chinese government bonds. Other niches in the asset class (hybrids and ‘rising stars’) are also worth considering. For decorrelation purposes, certain structured products and hedge funds with a moderate risk profile can replace the more conventional possibility of corporate-bond coupon payments, though at a price of reduced liquidity.

As for capital gains, equities will most likely continue to get a lift from further earnings growth in 2022. However, this will slow down once the liquidity provided by the central banks dries up, raising the prospect of a bumpier or riskier ride for equities next year. That’s why it makes sense to invest in megatrends with enduringly higher growth prospects.

Although this asset class now commands a rich valuation by past standards, it remains affordable in relative terms if we take into account the level of interest rates, especially in non-US markets. Lastly, unlisted equities (private equity) offer the best risk-reward profile for targeting capital gains. However, the average investment period – longer because of the segment’s lower liquidity – tends to restrict portfolio allocations.

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