In brief

• Rising bond yields and increased volatility in bond markets are challenging bonds long-held role in portfolios.
• Core real assets can provide income that is not correlated to public equity markets.
• Investors will need to assess how to maximize their risk budget and liquidity budget in achieving portfolio income objectives. 

Finding protection and income in the bond market has been a challenge facing investors ever since central banks embarked on the path of extraordinary policy measures. The challenge is looking just as difficult as central banks are set to reverse those same policies. Investors looking to replenish the income and diversification in their portfolio may find the solution in private markets and core real assets.

Bond yields have surged in recent days as the markets reprice the risk of higher and more persistent inflation and a U.S. Federal Reserve (Fed) that is increasingly determined to stamp out inflation before it becomes ingrained into inflation expectations. Fed committee officials have done little to push back on the idea that the Fed could increase interest rates by 50 basis points in May and potentially at other meetings this year.

The sell-off in bond markets has been swift. In the two weeks to 25 March the policy sensitive 2-year U.S. Treasury has increased by 55bps and the 10-year yield by a slightly smaller 48bps. 

The fall in bond prices comes when conviction in the equity market remains low and options to add ballast to portfolios from public bond markets limited. For many, the bond market may be broken, at least for now. Adding core government bonds provides some offset to a growth shock, but no income as the yield in real terms remains firmly in negative territory. At the other end of the fixed income spectrum, increasing allocation to high yield or emerging market debt increases the equity-like exposure of portfolio given the higher correlation of these fixed income sectors to the equity market.

The drive for uncorrelated income has already led investors to private market and this trend will continue, particularly in core real assets. Core asset are defined as those where a greater proportion of the total return comes from income, the underlying cash flows are persistent and often contracted and the overall returns have lower volatility as a result. These assets include real estate, infrastructure and transport. 

Exhibit 1: Equity market correlations and yields
Hedge adjusted yield, last 12 months
Source: Bloomberg, Gilberto-Levy, NCREIF, MSCI, FactSet, ICE, J.P. Morgan Asset Management. *CML is commercial mortgage loans. Fixed income shown above are represented by Bloomberg indices except for EMD and ABS – U.S. Aggregate; MBS: U.S. Aggregate Securitized - MBS; U.S. corps: U.S. Corporates; Munis: Muni Bond 10-year; U.S. HY: Corporate High Yield; TIPS: Treasury Inflation-Protected Securities (TIPS); Floating Rate: U.S. Floating Rate; Convertibles: U.S. Convertibles Composite; ABS: J.P. Morgan ABS Index; EMD ($): J.P. Morgan EMBIG Diversified Index; EMD (LCL): J.P. Morgan GBI EM Global Diversified Index; EM Corp: J.P. Morgan CEMBI Broad Diversified Index; Euro Corp.: Euro Aggregate Corporate Index; Euro HY: Pan-European High Yield Index; U.S. Real Estate: NCREIF Property Index – ODCE ; Europe Real Estate: Market weighted-avg. of MSCI Global Property Fund Indices - U.K. & Cont. Europe; APAC Real Estate: MSCI Global Property Index - Asia-Pacific; Global infra.: MSCI Global Quarterly Infrastructure Asset Index (equal weighted blend; U.S. Direct Lending: Cliffwater Direct Lending Index; Timber: NCREIF Timberland Property Index (U.S.); Transport returns and yield are derived from a J.P. Morgan Asset Management index; CML – Senior: Gilberto-Levy Commercial Mortgage Performance Aggregate Index. Convertibles yield is based on the U.S. portion of the Bloomberg Global Convertibles. Country yields are represented by the global aggregate for each country. Yield and return information based on bellwethers for Treasury securities. U.S. Real Estate yield is calculated using the MSCI Global Property Fund Index – North America. Correlations are based on quarterly return over the past 10 years through 31/12/2021, except Infra, Transport, and Europe, and APAC Real Estate, which are through 30/09/2021. International fixed income sector correlations are in hedged U.S. dollar returns except EMD local index. All yields are as of 31/12/2021, except Direct Lending, Infrastructure and U.S, Europe, and APAC Real Estate which are as of 30/09/2021.
Data is based on availability as of 28/02/2022.

As Exhibit 1 shows, these are the assets that sit in the middle of the chart, with almost no correlation to the equity market but offering up credit-like levels of income. The other quality these assets hold is that they offer some degree of inflation protection given that underlying cash flows may be indexed to inflation.

Real estate is perhaps the most debated of the real assets given the impact that the pandemic has had on reshaping how people work and how they spend. However, real estate has historically performed better when inflation is high and rising as underlying rents will rise with inflation, driving profitability and performance. Over the past 42 years, the U.S. real estate market has on average returned close to 12% during periods of high and rising inflation, almost double the 6.6% when inflation is low and falling (See page 19 of the Guide to Alternatives).

Infrastructure is another asset that consistently delivers income that is uncorrelated to public equity markets. The war in Ukraine and surge in energy prices has increased the focus on energy independence, or at least diversified sources of energy production, and with it the shift to renewable energy production. This creates opportunities for infrastructure managers as the pipeline of projects increases, creating new investment opportunities to deploy capital.

Some investors may look at today’s energy markets and see return opportunities in raw commodity prices and as a mean to hedge inflation. However, this overlooks the longer term theme of income generation from assets that are not sensitive to the economic cycle.

Transport and shipping has been one of the reasons that inflation rose last year as ports and shipping were disrupted. The current round of COVID-19-related restrictions in China has the potential to stall the slow improvement in the supply chain, adding to nearer term inflationary pressures. While such pressures would be a negative for consumers, they are likely to be less so for the owners of those shipping assets and the underlying investors given the contracted nature of cash flows. Activity has started the year strongly and port calls globally are higher than in the pandemic-impacted years of 2020 and 2021 and even above the same period in 2019. 

Investment implications

Correlations between equities and bonds have spiked in times of stress this year, demonstrating the need for investors to think broader when it comes to increasing diversification in portfolios and seeking out uncorrelated sources of income.

Alternatives and core real assets such as real estate, infrastructure and transport can help in this regard. These assets deliver higher and more consistent levels of income which are not correlated to equity markets.

These assets have an additional benefit of offering cash flows that move with inflation rather than being eroded by it.

The trade-offs being made increase from simple risk and return to those concerning liquidity. This adds an additional consideration about how investors can effectively use not only their risk budget in delivering on investment objectives, but their liquidity budget as well. 

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