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Investing According to Your Risk Tolerance: 3 Ideas for 2021

Investors are being penalised for holding cash and not putting their money to work.

In an environment of extremely accommodative monetary policy with policy rates at a record-low 0.1% and term deposit rates not much higher, investors are increasingly concerned about how they can invest and meet their investment objectives. Many investors are holding too much cash, reducing their ability to meet those objectives. The opportunity cost of sitting on large pools of cash is high, particularly when credit markets still present some significant opportunities and the Australian bond curve has been steepening.

Below are three ideas for bond investors in 2021, catering to different liquidity requirements and levels of risk tolerance.

Lower risk tolerance: Pursue a higher return than cash in short-term bond strategies

While returns on cash may be historically low, many investors are anxious about losing money, particularly given recent market volatility. For investors with a lower risk tolerance and/or higher liquidity needs, an actively managed short-term bond strategy can help enhance returns and preserve capital, while maintaining daily liquidity.

These strategies can take advantage of opportunities in shorter-term bonds and credit markets to generate returns above the cash rate. They offer defensive characteristics by maintaining a high average credit quality rating, along with a structural level of duration (sensitivity to interest rates) at a relatively attractive entry point versus recent history, which should allow them to deliver returns if we experience volatility in risk markets. In addition, they typically run a structurally lower level of duration than core Australian bond allocations, so if interest rates were to rise in the future, investors should not be overly exposed.

Medium risk tolerance: Seek out the opportunities in public bond markets

For investors with a slightly higher risk tolerance, we see opportunities to earn more from domestic bond investments while taking on manageable risk. At the higher quality end of the spectrum, we favour assets rated AAA and senior tranches of residential mortgage-backed securities (RMBS), which are backed by robust cash flows. There are still pockets of the investment grade credit universe with attractive valuations and scope to recover from the pandemic shock. We see opportunities in sectors such as leisure, hospitality and gaming. However, careful credit selection is required to differentiate the winners from the losers.

While central bank support remains strong, we also favour Australian semi-government debt, particularly 5-year to 7-year maturities, which offer better value than shorter-duration bonds. These bonds are expected to “roll down” the yield curve towards the Reserve Bank of Australia’s three-year yield curve control target of 10 basis points (bps). Although spreads for most semi-government bonds have narrowed to historically tight levels, we believe the sector still offers value amid this environment of ultra-low cash rates.

Higher risk tolerance: Selectively take advantage of the illiquidity premium

For those investors with longer time horizons who can tolerate some risk, we think there are significant opportunities in the more illiquid areas of the credit market – private credit, special situations, and some areas of the distressed credit market.

Most available risk premiums may be fair, currently, but they are not cheap. When looking to generate a return above the “risk-free” rate, investors should consider the illiquidity risk premium, which is typically underrepresented in portfolios. The illiquidity premium is essentially the additional compensation to investors for limiting their ability to take advantage of future market dislocations, should they arise, as their capital is locked up for a specified period. As a result, illiquid investments should offer a premium in the form of higher yield expectations. These comparably higher yields can be a helpful income-generating component of a portfolio.

In our view, alternative credit now looks extremely attractive on a relative basis. Central banks have been supporting the most liquid, traditional areas of capital markets. A lot of that liquidity hasn't found its way into the less liquid, alternative areas of credit markets such as private corporate debt or real estate opportunities. For investors prepared to have some of their portfolio allocated to less liquid assets, there is the potential to earn high single-digit returns in exchange for locking-up some assets for a period of time.

Building an efficient portfolio: Consider all available risk premiums

With short-term interest rates at 0.1%, investors are being penalised for holding cash and not putting their money to work. Now more than ever, investors need to consider all of the available risk premiums when building an efficient portfolio. This may mean a number of things, including boosting diversification and taking advantage of unique opportunities caused by the current dislocations in areas like alternative credit.

The Author

Robert Mead

Head of Australia, Co-head of Asia-Pacific Portfolio Management

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PIMCO Australia Pty Ltd ABN 54 084 280 508, AFSL 246862. This publication has been prepared without taking into account the objectives, financial situation or needs of investors. Before making an investment decision, investors should obtain professional advice and consider whether the information contained herein is appropriate having regard to their objectives, financial situation and needs.

All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be appropriate for all investors. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee, there is no assurance that private guarantors will meet their obligations. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Private credit and equity strategies involve a high degree of risk and prospective investors are advised that these strategies are appropriate only for persons of adequate financial means who have no need for liquidity with respect to their investment and who can bear the economic risk, including the possible complete loss, of their investment. Management risk is the risk that the investment techniques and risk analyses applied by PIMCO will not produce the desired results, and that certain policies or developments may affect the investment techniques available to PIMCO in connection with managing the strategy.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.

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