As the search for higher yields intensifies in today’s relatively low-rate environment, investment professionals are increasingly drawn to non-traditional fixed interest products to meet the income needs of their clients. Heathcote Investment Partners founder, Clayton Coplestone, explains why ‘exotic’ fixed income strategies also come with non-traditional risks…
High-yield bonds, leveraged loans, collateralised loan obligations (CLOs), and other structured credit instruments are being championed as potential sources of enhanced returns. However, these higher-risk fixed income products come with inherent risks that can undermine the very stability and capital preservation that fixed income assets are traditionally meant to provide.
While the promise of greater returns may be appealing, investment professionals must exercise caution and fully understand the risks involved in these more exotic fixed income products. Failing to do so could result in significant losses and a breakdown of the risk-management framework that forms the foundation of many portfolios.
At the core of many of the more exciting fixed income products is heightened credit risk. High-yield bonds, for example, are issued by companies with lower credit ratings, meaning they carry a higher probability of default.
The pursuit of yield may seem attractive when returns from investment-grade bonds remain low, but it’s important for investment professionals to evaluate the creditworthiness of issuers thoroughly and to appraise the relevance for their clients’ portfolios. With a greater risk of default, the possibility of significant losses increases, particularly if an issuer fails to meet its debt obligations – something that we haven’t seen for some years.
For many investors, especially those focused on capital preservation, the default risk inherent in high-yield bonds and other exotic debt instruments is a substantial concern.
Leveraged loans and CLOs also expose investors to greater credit risk, as they often involve borrowing by companies with weaker credit profiles or financial stability. Even though these instruments are often secured by underlying assets, there is no guarantee that the collateral will fully cover any losses in the event of a default.
When incorporating such products into client portfolios, investment professionals need to assess not only the credit quality of the underlying issuers but also the risk of cascading defaults, especially in a downturn.
Interest rate movements can be one of the most significant risks to fixed income investments and these adventurous products are often more vulnerable to changes in rates than traditional bonds. Many high-yield bonds, CLOs, and structured credit products are sensitive to rising interest rates, which can lead to price volatility.
Again, this volatility is particularly concerning for those seeking the safety and predictability that fixed income traditionally provides. For instance, long-duration high-yield bonds are especially vulnerable to interest rate increases. As rates rise, the price of these bonds can fall sharply, reducing the overall value of the portfolio.
Similarly, leveraged loans and CLOs are often floating-rate instruments, meaning their interest payments adjust with market rates. While this can be beneficial in certain rising rate environments, it can also lead to increased borrowing costs for the underlying issuers.
If these companies struggle to meet higher interest payments, the risk of default can increase, exacerbating the potential for losses.
It’s vital that investment advisers pay close attention to this interest rate risk, especially when structuring client portfolios with seemingly glamourous fixed income products.
Understanding the sensitivity of these assets to interest rate movements is essential in matching the exposures to clients’ risk tolerance, investment horizon and broader portfolio goals.
One of the significant drawbacks of more colourful fixed income instruments such as CLOs, leveraged loans and certain structured credit products is their lower liquidity.
Unlike traditional government bonds or investment-grade corporate bonds, which are typically easy to buy and sell in secondary markets, many of these products can be difficult to liquidate in times of market stress – despite the brochure claims of ‘daily liquidity’.
During periods of market downturns or financial crises the lack of willing and able counterparties can exacerbate losses as investors may struggle to sell these positions without incurring significant price discounts. Liquidity risk is particularly pertinent for investors who may need to access their investments quickly or during market dislocations.
Many of these exotic fixed income products also involve complex financial structures, making them difficult to fully understand without deep expertise. CLOs, for example, are made up of tranches with varying degrees of risk and return and understanding how the underlying assets perform over time can be challenging.
These complexities make it difficult for even seasoned investment professionals to accurately assess the full risk profile of such investments. Furthermore, some of these instruments are not as transparent as traditional fixed income products. The underlying assets and cash flows may be difficult to track, and there is often limited information available on the performance of these products. This lack of transparency can lead to a mispricing of risk and an overestimation of their potential returns.
In some cases, investors may fail to account for the full scope of the risks involved, which can lead to poor decision-making and unintended portfolio exposures. Incorporating these products into client portfolios requires investment advisers to not only understand the mechanics of these instruments but also to have access to accurate and timely information.
One of the key considerations for investment professionals is ensuring that the risk-return profile of any product aligns with the client’s objectives. Exotic fixed income products may offer higher yields, but these returns come at the cost of elevated risk.
If the client’s goal is to preserve capital or generate stable income, these higher-risk instruments may not be the appropriate choice. Instead, they may expose clients to a higher likelihood of volatility and loss, especially during times of market stress.
As the demand for higher yields continues to grow, investment advisers must approach more exotic fixed income products with caution. While these products may offer attractive returns, they come with heightened risks—credit risk, interest rate sensitivity, liquidity challenges, and complexity—that can undermine the stability and predictability traditionally associated with fixed income investments, and the role that they should play in client’s portfolios.
Careful risk assessment, ongoing monitoring, and a deep understanding of the underlying products are essential for advisers to make ongoing and informed decisions on behalf of their clients. With these risks in mind, advisers should remain diligent in ensuring that their recommendations align with their clients’ financial objectives, risk tolerance, and long-term investment goals.