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Ways for financial advisers to face down the debt supercycle

High global debt levels have weakened global economic growth to the point where the credit cycle has started to drive the business cycle rather than vice versa

Aug 30, 2016 @ 11:05 am

By Roger Early

With the rapid assumption of debt by governments, businesses, and consumers worldwide, global economies are finding themselves in the midst of a debt supercycle.

This period of intense and persistent increase in leverage throughout the global economy presents a number of challenges, but the primary result is sluggish global economic growth. Low economic growth presents risks for companies and governments throughout the world, and brings with it elevated credit risk.

Compounding the problem, high global debt levels have weakened global economic growth to the point where, unlike in previous experiences, the credit cycle has started to drive the business cycle rather than vice versa.

We know by now that the policy responses since the global financial crisis began have had mixed results, but even at their best they are little more than temporary fixes, and meaningful economic growth remains elusive in many parts of the world. Fixed-income investors should adapt to the environment and navigate carefully. There are several big-picture implications for fixed income investors, including that they'll need to accept that returns could be lower than historical norms, try to avoid risks and value traps, and recognize the shortcomings of passive investments.

As a result of the low-rate environment and elevated risk level across the fixed-income spectrum, investors need to adjust their return expectations — unless they are willing to step out further on the yield curve and assume more interest-rate risk, or take on more credit risk by accepting lower quality bonds.

The risk-reward scenario narrows in a low-yield environment, when there's not ample income to attempt to cushion returns. In an environment in which high-yield bonds, for example, have 10% coupons, investors may be willing to take on more risk because the returns are substantially larger than the amount they can earn from more conservative investments. Spreads have narrowed considerably, though, and as a result many investors are going to simply have to accept lower returns than in the past.

An index investment can be perceived as a good strategy during positive market environments. Consider what can happen in down markets and how passively managed investments would follow that downward trend. With active management, managers can research the credit spectrum and tailor investments to the current market conditions, making active management appealing in an environment ripe with credit risk and when negative yields are becoming more prevalent.

Investors also need to be balanced in how they perceive credit risk in a more globalized debt supercycle, particularly as credit risk recently has become the impetus of some of the volatility. There can be opportunities in such an environment, but taking advantage of them requires strong macro management and fundamental security-selection skills. Keep in mind that a more defensive approach, such as investing for more stable income, may at times be the appropriate choice, rather than looking for price appreciation driven by the market.

Yield-focused portfolios with riskier assets clearly are tempting in a low-growth, low-rate environment. It's important to remember, the heightened degree of assumed risk of certain types of securities, especially against the backdrop of a low-growth environment. For some, a small allocation to such high-yielding securities might be a valid consideration. Conventional wisdom suggests that those typically would introduce a certain amount of risk into a portfolio.

Economists and investors around the world have been focused on interest-rate risk since the end of the global financial crisis. But a new breed of interest-rate risk has been introduced because of the outsized role that's been played by central banks in supporting markets and, in turn, the global economy.

When and how the world can be extricated from the debt supercycle may be unclear, but the risk of this uncertainty should be monitored and managed in targeting the return on investments. When constructing fixed-income portfolios, investors should consider focusing on solutions that offer capital preservation and stable income in an effort helps manage risks and protect against difficult environments.

Roger Early is head of fixed income at Delaware Investments.

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