In an environment that has seen both fixed income and equity markets rattled by rising interest rates and geopolitical tensions, can bonds still add value as portfolio diversifiers? Aubrey Basdeo, BlackRock’s Head of Canadian Fixed Income, says how best to maximize fixed income’s contribution to a portfolio depends on where we are in the business cycle – and that’s why it’s so critical to stay active with bonds.

What factors are driving stocks and bonds down?

For the bond market, it’s higher interest rates. Bond markets have been selling off for much of the year as we are in the midst of a hiking cycle. Both the Bank of Canada (BoC) and the US Federal Reserve (Fed) have been raising the overnight rate to drain excess liquidity and prevent their economies from overheating. For the stock market, higher interest rates are initially viewed as good because they suggest central banks are acknowledging the economy is healthy and growing at an above-trend pace. At some point, as financial conditions become restrictive, the stock market may reflect that higher rates are likely to have a negative impact on future earnings and will start to reprice lower. Other notable factors today, such as global trade tensions and rising geopolitical risks, are seen as growth drags and serve to put additional pressure on equity markets.

How is your team responding to greater correlation between asset classes?

That is a conundrum for investors. The fixed-income portion of a portfolio is typically the volatility dampener or ballast, and when assets are highly correlated and selling off in tandem there’s nowhere to hide. So you really have to think about both the asset mix and where you want to be in each asset class.

In fixed-income, we carefully consider the balance of credit or spread risk and interest rate risk. At the beginning of a hiking cycle, the composition tends to be a shorter duration with more spread risk relative to interest rate risk. But is the market now signaling that central banks are close to their target and the economy is starting to cool? If that’s the case, you will likely want to take on more interest rate risk and less spread risk.

How are you maximizing the diversification benefits of bonds?

You have to be an active investor in a situation like this that really asks you to figure out where you are in the business cycle. In the early stages of a period in which central banks are being active and raising rates, it’s all about generating returns from spread risk, diversifying across the range of spread assets such as high-yield, investment-grade and emerging market bonds. As the business cycle ages, you will need to reallocate your spread exposure both in terms of the credit quality mix and overall relative exposure. At the same time, you will be monitoring for signs that higher rates are near peaking and look to increase interest rate risk exposure by adding duration to the portfolio. Those are all active decisions.