The missing asset class in portfolio diversification

With interest rates at near-historic lows, Australian investors face a conundrum: invest in low-yielding fixed interest assets and accept an income reduction, or contend with the high volatility associated with equities in pursuit of higher returns.

This is an unnecessary dilemma because there is a third alternative, a world of income-producing securities that sits comfortably in the gap between fixed interest and equities, an asset class that many investors are simply not aware of. It is the missing asset class in portfolio diversification.

This asset class offers both higher levels of income and reduced volatility (relative to equities), and is well suited to investors seeking an alternative in the prevailing low interest rate environment.

Today global credit markets have the potential to offer an attractive combination of security and predictability of income. This is the missing asset class.

Other markets are well aware of the benefits of global credit as an asset class.

We know Australians have notably larger allocations to equities and cash/deposits than comparable nations. This is due in large part to a local country investment bias towards the Australian share market.

As investors move from the wealth accumulation phase of their lives to drawing down on that wealth to provide income in retirement, they may need to consider income-generating investments that pose less risk to their capital. Global credit markets are potentially an attractive option in this context.

So what’s so good about credit?

Seniority: Credit investors have priority of payment above equity investors. A creditor generally has a legal right to be paid before anyone else, including shareholders. Furthermore, creditors are entitled to take legal action to recover their investment. In the event of a default (such things happen, and are planned for), creditors generally rank ahead of suppliers and others in the queue for payment (note that the unfortunate shareholders rank last in a situation like this).
Security: In addition to seniority, some credit instruments also provide investors with the benefit of security over specific assets of the borrower. This normally takes the form of a mortgage over property and/or other realisable assets.
Global liquidity: The global credit market is large and deep. For example, the US corporate debt market alone is worth US$8.7 trillion. The size of the market, the number and size of issuers, the number and size of investors, and the wide variety of credit products can help an active manager access liquidity, even in difficult times.
Yield: Credit markets typically offer higher income than equities and government bonds, with historically lower volatility than equities.
Diversification: Credit issuers come from many industry sectors in many regions of the world, creating more credit opportunities than are available locally. Global credit markets give active managers and investors the opportunity to achieve a high level of diversification – an important factor for credit portfolios. Downgrades and defaults tend to be unexpected and occur in industry clusters. Global diversification reduces overall volatility and mitigates the impact of defaults.

Finally, there are many types of credit instruments, enabling an active manager with a global perspective to construct a portfolio of diversified investments.

Credit sectors include: