Diversification: How can it help in today’s market conditions?

Here, we explore the importance of diversification in Fixed Income portfolios – and why it is particularly critical when investing in a buy and maintain credit strategy. Is now the right time to consider a diversified buy and maintain strategy?

1. Why is diversification important in Fixed Income?

The asymmetric return profile of fixed income instruments means mitigating downside risk is particularly important – the best case scenario is that you get par at maturity; the worst case (in the event of a default) is that you lose everything. Investing in a concentrated approach which takes a smaller number of “bets” to generate return increases your exposure to the worst case scenario – particularly in periods of market stress, or when unexpected events occur.

Everyone knows that avoiding the losers in corporate bond investing is down to strong credit research. However, some risks are hard – if not impossible – to predict, like fraud. In these instances being diversified across a wide range of names can provide an additional layer of protection for your returns.

Diversification doesn’t stop at the name level though – investors should also think about spreading their risk across different sectors and countries to avoid losing out when market “bubbles” burst. This is particularly true in times of market stress and volatility – which we expect to see more of in 2018.

2. Can you have too much of a good thing?

While the benefits of diversification are clear, it is possible to be over-diversified, and this has a cost.

It could be argued, for example, that if spreading your risk across many names is good, then replicating a full  corporate bond index (through a passive fund, for example) is the best option out there. Smart investors realise the flaw in the argument though: when you replicate an index you also replicate all of its problems. Investors end up holding poorly valued and poor quality bonds right alongside the better ones. They also end up over-exposed to the sectors and countries with the most issuance, leaving them open to systemic risks. All this has a potential cost in terms of performance leakage.

Optimal diversification is an art rather than a science – and it’s important that your asset manager get the balance right.

3. Is now the right time to invest in buy and maintain credit? 

Given the current levels of political uncertainty and increased market volatility, investors may well ask whether now is a good time to invest in a diversified buy and maintain credit strategy.

AXA Investment Managers’ buy and maintain credit strategy is designed to perform over the full market cycle through selecting attractive bonds with strong fundamentals – then holding them to maturity in order to avoid the costly performance leakage associated with high turnover. We aim to maintain optimally diversified portfolios through a smart top-down framework which minimises biases to any one name, sector or region – thus mitigating the impact of issuer-specific risks, or systemic shocks in the market.

We also incorporate forward-looking dimensions into our diversification framework, taking thematic issues like Responsible Investment into account, and avoiding over-concentration (or in some cases, any exposure at all) in areas liable to face sustainability problems in the future based on ESG factors.

A balanced, well-diversified buy and maintain strategy can be an attractive choice regardless of where we are in the market cycle.