Where hidden risks lurk

Jun 26, 2017
By BlackRock

For many investors, bonds are deemed the “safety net” in their portfolio. In fact, in a recent BlackRock survey of investors, 31% of respondents —and 44% of those who considered themselves knowledgeable about fixed income — believed that when it comes to fixed income investing, “you can’t lose your money.”

In the past 30 years of falling rates and rising prices, that may have seemed an irrefutable truth. But times are changing, and expectations for interest rates to rise off of their low base are destabilizing the risk profile in investor portfolios in ways that may not be well understood.

Patrick Nolan, Portfolio Strategist with the BlackRock Portfolio Solutions team, discusses a recent analysis the team conducted of 859 portfolios provided by financial advisors. The results revealed some hidden risks investors may be unaware are lurking in their fixed income portfolios.

Tell us about the study.

In addition to submitting their portfolios for analysis, we asked the advisors to identify the primary purpose of fixed income in the portfolio.

The choices were to:

  • diversify equity risk
  • seek stability
  • generate income

We then categorized the portfolios based on their overall asset allocation:

  • Conservative: Portfolios containing less than 40% equities.
  • Moderate: Portfolios containing 40%-70% equities.
  • Aggressive: Portfolios containing more than 70% equities.

This had us arrive at a total of nine combinations. The most popular category by far was moderate, and the most popular pairing was moderate/diversify equity risk.

What risks did you uncover?

Our analysis surfaced three key risks:

  1. Equity risk. A concentration in economic risk factors; these portfolios could be hindered by recession, for example.
  2. Interest rate risk. A concentration in rate-sensitive investments, suggesting these portfolios could be hampered by rising rates.
  3. Yield deficiency risk. An opportunity cost, suggesting these portfolios can generate more yield than they are.

The majority of portfolios exhibited higher risk levels than a representative benchmark, for two main reasons: The equity components displayed more volatility than equity benchmarks, and other investments in the portfolio insufficiently diversified the equity risk. On the latter point, we found that bond sleeves were more often than not heavy on credit risk, essentially limiting the ability to diversify equity risk in the portfolio.

What did you find most striking?

Perhaps most striking was that bond portfolios were very often missing out on exactly what they were trying to achieve.

For example, the hidden risk of all portfolios (conservative, moderate and aggressive) with the goal of diversifying stocks was equity risk. The fixed income sleeves did not contain sufficient interest rate risk to offset equity and credit risk.

Equally noteworthy: Conservative and moderate portfolios seeking stability were actually unstable because they contained too much interest rate risk. In an effort to avoid credit risk, these portfolios leaned heavily into higher-quality bonds and accrued too much interest rate exposure. If rates rise, they are vulnerable to losses.

Summary of hidden risks

Summary of hidden risks

Source: BlackRock Portfolio Solutions analysis of 859 advisor portfolios. See “Notes” below.

Why is the bond sleeve failing to deliver what’s expected?

Markets are at least partly to blame. Years of low yields have forced many investors into riskier, equity-aligned credits in the search for income, increasing overall equity risk in their portfolios. At the same time, an expected reversal in rates has caused many advisors and investors to shy away from duration-sensitive assets, despite the fact that their portfolios may need interest rate risk as an offset to accumulated credit and equity risk.

How can investors course-correct?

Generally speaking, it comes down to balancing risks. If you’re heavy on equity risk, you may need to add high-quality traditional bonds. If you’re overweight interest rate risk, you may need to add credit risk as an offset. That might mean high yield bonds or certain types of international debt. But there are two important points to be made here:

First, know that the bond sleeve does not function on its own. Make sure you are focused on the total portfolio and its ability to maximize risk-adjusted returns. Second, be sure to diversify your portfolio by risk, not just by asset class.

Just because we call a security a stock or a bond doesn’t mean it will always act like one. We found that all three moderate pairings displayed equity risk in the area of 90%, yet the portfolios had average equity allocations ranging from 52% to 56%. It’s important to look beyond the labels to understand the risk drivers behind each asset you’re choosing for your portfolio. Only then can you truly diversify your portfolio.


Patrick Nolan is Portfolio Strategist in BlackRock’s Portfolio Solutions group.