Out of equities into bonds: is there a better option? (page 2 of 2)

Hence, not only is there likely to be a net shift into fixed income: there is also likely to be within fixed income a shift towards higher yielding and diversifying assets.

Why the higher yielding assets are to be favoured should be clear from what we have already said and from the observation that, for example, 10-year government bond yields are under 4% in the US and under 1% in Japan. However, diversification is also crucial.

Take for example emerging market debt as a potential asset class to diversify into. Firstly, the returns are strong with reasonable levels of risk. Secondly, it has negative correlations to US Treasuries and other G7 government bonds and is counter-cyclical to the G7 business cycle.

Looking at these characteristics more closely - firstly good returns with reasonable risk - the ten-year gross return of Ashmore's flagship fund as an example is above 25% per annum, and the monthly volatility of index returns has reduced substantially since 1998 and is now, at around 8%, half that of the S&P500.

Also, though a country defaulting hits the headlines, default risk is historically around 0.5% per annum or about one tenth that of comparably rated High Yield bonds - i.e. this risk is not as high as often perceived. There need not be any currency risk, either, as bonds are denominated in dollars or Euros. Also, the market has matured since the mid-90s, and now has a more mature investor base (institutional investors not hedge funds).

Since 1998 and the reduction of leverage in the market and move from fixed to floating exchange rates, financial contagion from one emerging market country to another the other side of the world has disappeared. The remaining form of contagion is that which affects all markets: where contagion originates in the US or G7, as exemplified by contagion from the US to Brazil last year as US banks withdrew credit due to problems at home.

Secondly, there are diversification benefits from emerging debt being counter-cyclical to the business cycle: the global reduction in interest rates accompanying economic slowdown reduces debt service costs for countries, increasing creditworthiness.

This is more dominant than any business cycle effects. This is in part because emerging debt is a liquid market driven by rapidly changing fundamentals with most value from investment strategies achievable within a year (another feature of which is that specialist active management can deliver strong and consistent out-performance). Hence the multi-year impact of recession or global slowdown are less important as determinants of investment return than short and medium term factors - including reduced interest rates.

Likewise emerging debt is counter-cyclical to any global recession induced by high oil prices due to a number of significant oil producing countries in the asset class.

Hence not just the diversification benefits of emerging debt are attractive, but so is the ability to protect a pension fund portfolio from a number of negative scenarios - for example an oil price shock induced by an escalation in the Middle East. It is noteworthy that of all major credit markets emerging debt was least damaged by 9/11.

Typically putting emerging debt into a portfolio both reduces volatility and increases return, but what is the exception? An analysis of negative months in the Lehman Aggregate highlights five periods when there have been sustained losses over the last ten years, and in four of these emerging debt has delivered a positive return.

The exception was in 1994, when severe Fed. tightening was also combined with growing problems in Mexico, culminating just after the period with devaluation in December 1994. Hence it is in a scenario of a major series of interest rates increases that emerging debt may not help. In all other scenarios, including that of gradually rising interest rates (which tends to be associated with an increase in risk appetite), an allocation to emerging debt seems to reduce risk.

For these various diversification and risk scenario reasons allocations to emerging market debt are increasing. However, emerging debt is just one example of an attractive asset class increasingly being sought out.

Its characteristics are not particularly new, but the motivation to overcome prejudices and invest in such an asset class are now greater than when global equities performed well and pension funds were better funded. It is to similar high yielding diversifying asset classes that pension funds must increasingly look in order to cope with the secular bear market in equities and high target rates of return.