Mitigating market risks with multi-asset income

Broad market consensus is that the U.S. Federal Reserve (Fed) has reached peak rates at the current range of 5.25% to 5.50%. However, there’s still uncertainty on how monetary policy will unfold over the next several months, especially around the timing and number of potential interest-rate cuts for 2024. Based on this lack of clarity, income investors may want to consider the merits of a multi-asset income portfolio for mitigating potential persistent market risks.
 

1         Inflation risk

For income investors, the risk of rising inflation is that it reduces real returns on fixed income and erodes the purchasing power of capital over time. Both the January and February Consumer Price Index (CPI) was higher than market expectations, increasing 3.1% and 3.2%, respectively, year over year. While this is a steady decline from a high of 9.1% in June 2022, the final push toward the Fed’s 2% inflation target may prove the most difficult. If disinflation starts to slow, investors may be well placed to retain the flexibility of a portfolio that can allocate to growth assets to protect against potential sticky inflation risk. 

Sticky inflation presents challenges for bonds’ real returns

^{Source: Bloomberg, Multi-Asset Solutions Team, Manulife Investment Management, February 2024. 10-year U.S. Treasury average yield to maturity 8/1/23–1/31/24. Intermediate-term bonds are represented by the Bloomberg U.S. Aggregate Bond Index, average yield to maturity 8/1/23–1/31/24. Headline CPI 6-month average as of 1/31/24.}
 

2         Interest-rate and duration risk

Interest-rate risk affects income investors by reducing the price of already-issued bond securities. As interest rates rise, newly issued bonds offer higher yields, reducing the attractiveness and value of existing bonds, especially those with a long time to maturity, which introduces duration risk. If the Fed has reached peak rates, as is widely believed, it’s unlikely that interest rates will increase further in this cycle—provided there are no significant unexpected events or meaningful economic data surprises. Duration risk increases when inflation surprises to the upside. However, in periods when inflation is moderating, increasing exposure to duration within fixed income seeks to take advantage of longer-term attractive returns and can help to protect portfolios against the risks of a potential recession. Multi-asset portfolios are often well placed to invest across the duration spectrum to find potential opportunities for investors.
 

3         Credit risk

High-yield bonds often form a component of income portfolios based on their potential to deliver high interest income; however, higher expected returns mean these securities also have higher credit risk, which is the risk of potentially defaulting on the repayment of debt. In periods when credit risk is considered high, multi-asset income portfolios may be able to diversify risk through allocations to investment-grade bonds and/or high-yielding equities. Widening credit spreads often indicate worsening economic conditions, while narrowing spreads typically indicate an improvement in economic outlook. However, when looking at prevailing market conditions, investors should be cognizant that there’s often a lagged effect of monetary policy on credit risk. If interest rates remain higher for longer, credit defaults may increase as time passes even as broad equity indexes may be performing well. Being invested in a portfolio that can actively manage this risk while a soft landing remains uncertain may add value for investors concerned with trailing credit risk.

4         Equity risk

When income investors add exposure to equities, it’s typically to stocks that offer the potential for high dividends with the aim of adding to a portfolio’s total yield. High dividend-paying stocks can be found across sectors and within varying equity factors, including U.S. large cap, mid cap, and/or small cap. In a multi-asset income portfolio, investors gain diversified exposure across equity factors, which also diversifies equity risk, reducing concentration toward any one sector or factor.

A broad investment tool kit within multi-asset income investing helps to diversify risk exposures

5         Manager and investment style risk

Multi-asset income portfolios that follow a multimanager approach can help to diversify single manager and investment style risk. With multiple underlying managers following active and passive investment styles, multimanaged portfolios have the potential to add value in periods when active security selection may have more opportunities for outperformance. At the same time, passive investment styles help to lower total costs and should form a key component of an income investor’s tool kit, in our view, when constructing an efficient portfolio.
 

A wider risk management tool kit

Multi-asset income portfolios may offer a practical solution for income investors looking to manage potential market risks, particularly as the economic landscape remains uncertain. These portfolios aim to generate consistent and stable high income by investing in a broad range of asset classes and asset class subsets. The result is diversification across a wider range of risks, including inflation, interest-rate fluctuations, credit risk, equity volatility, and manager/investment style risk. By leveraging an overall broader set of risk management tools, and allocating across asset classes, factors, and geographies, multi-asset income portfolios aim to help investors navigate markets while pursuing high income. 

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