Investors need to be careful they don’t “end up with equity-type risk” while hunting for better yields in the low-rate environment, says IOOF.
The company noted that the risk-free rate used to benchmark asset classes is currently close to zero, which “has huge implications for all asset classes”, notably bonds.
“Bond markets are now characterised by ‘return-free risk’ rather than ‘risk-free return’; with many bond markets earning negative returns, either in nominal or real terms, investors are not being rewarded for holding these instruments,” IOOF said.
“In this environment, it is very hard to hold sovereign bonds as they generate little or no return but can cause losses on a mark to market basis.”
Additionally, the relationship between bonds and equities – that falls in equity prices would see bond prices rise – is also “unlikely to occur now, or to a much lesser extent than in the past”, driving some investors to seek exposure in other fixed or floating debt instruments instead.
“The danger is that investors on the hunt for yield go too far out on the risk curve and end up with equity-type risk rather than bond-type risk,” IOOF said.
The company said value remained in certain private debt/credit instruments, though these would be negatively affected by a substantial increase in interest rates, and investors should use floating rate instruments” in high quality companies unlikely to be greatly affected by economic downturns or rate hikes.
“At this stage there does not seem to be the preconditions for a large increase in official interest rates and the risk of recession seems quite low in most countries around the world,” IOOF said.
“Thus, corporate debt, bank loans, mezzanine debt and selected bank hybrids all present opportunities in the current market – but one needs to be selective.”
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