When speaking about investments, a ‘barbell’ approach generally refers to deploying capital to the two poles of the risk spectrum – the very safe and the very risky – with the goal of creating a combined portfolio that offers strong risk-adjusted returns. The idea takes advantage of the diversification benefits available when investing in diverse asset categories since, under normal circumstances, safe assets and risk assets behave differently from one another.
In the current financial environment, however, such an approach may not be the best option. There are two primary reasons for this: the breakdown of the customary correlation relationships between safer and riskier asset categories, and the difficulties of pricing risk in the coronavirus era.
Under normal conditions, investors can expect safer assets like Treasury bonds, agency-backed mortgage bonds, and investment grade corporate credit to perform well in a ‘risk off’ scenario. However, in March, these asset groups fell in value alongside risk assets. According to research by Blackrock, the correlation between investment grade bonds and equities shot from -.09 in February to .40 in March. As the Fed has stepped into the mortgage, municipal and corporate bond markets, the relationship between these markets and equities has normalized. Unfortunately, the Fed’s liquidity facilities are meant to be temporary and the longer-term economic consequences of the crisis are unclear. Accordingly, investors shouldn’t ignore the potential for further abnormalities in the correlations between asset categories.
A second concern with a barbell approach relates to risk in the current investing climate. The Fed’s decision to enter just about every fixed income category has stabilized these markets but has also made it difficult to accurately assess risks. Since late March, the stock market has retraced a good deal of its losses, but investment grade spreads have rebounded even more. This resurgence is largely due to the reassurance that the Fed will provide a backstop in these bond markets. Yet while the Fed is providing a great deal of liquidity, the underlying credit issues remain and may become a problem depending upon how the medical and economic situation unfolds. High grade corporate and municipal borrowers will continue to be challenged and may need additional direct aid in order to maintain their longer-term financing needs. Given low nominal yields and a great deal of economic uncertainty, current prices of higher quality bonds may not accurately reflect the risks. Fighting the Fed is certainly a bad idea, but investing for no other reason than that the Fed is providing liquidity isn’t necessarily a great idea either.
The riskier side of the spectrum doesn’t suffer from as many Fed-related distortions (although some stock market frothiness may stem from investors thinking that the next logical for the Fed is to start buying equities), but still presents issues based on the unique nature of the coronavirus crisis. More aggressive factor and geographic tilts in small caps, value sectors, and emerging markets are at least worth considering in light of the damage already done and priced into these categories. However, unlike other cycles when these groups could be expected to outperform during an economic rebound, the nature of the current predicament makes this expectation less likely: Larger companies with stronger balance sheets, better access to capital markets, and (therefore) better prospects for survival continue to gain ground on their smaller rivals; traditional value sectors like manufacturing and energy face distinct challenges to revamp their business models; and many developing countries lack robust healthcare infrastructure and are therefore more susceptible to a catastrophic breakdown.
Fortunately, while the two ends of the risk scale present concerns, investments in the middle of the spectrum appear more attractive. For instance, high yield bonds seem well priced relative to equities. At current spread levels, investors are being fairly compensated for risk and can collect significant income as developments unfold. Coming out of past recessions, high yield fixed income has performed well but, if the economy lags over a long period, this asset category has the benefit of being more defensive than stocks. Additionally, some of the financial norms that are emerging (like slashed dividend payouts, a halt to company stock repurchases, and more restrictive lending covenants) may be broadly supportive of bond investment. High yield is also a beneficiary of Fed actions, which is just an added reason to like the category.
Bank loans are another area that has some appeal for many of the reasons mentioned above. At current price levels, the implied defaults in the bank loan market are extremely high, so a lot of bad news has already been discounted by the market. Given the seniority of loans in the capital structure, the prospect of recovering value when loan defaults occur provides a measure of protection that shouldn’t be taken for granted.
Hedged equity strategies that use options to gain stock market exposure also are worth consideration. Volatility levels may be much lower than in March but are still much higher than in past years. As a result, options prices are higher, so option-based strategies may allow investors to gain equity exposure in an efficient way. In past crises, implied volatility has remained elevated for a substantial amount of time, indicating that hedged equity strategies may be able to take advantage of higher options prices for an extended period.
Lastly, quality U.S. large cap growth stocks that will survive the stay-at-home environment and thrive when the economy reopens are also attractive. The U.S. policy response and structural advantages relative to other economies make it the safest place to ‘play a rebound’. Geographically, there are many cheaper markets, but the political structure of the E.U. dims prospects for a robust response from governments, and, as mentioned previously, the lack of health care-related infrastructure in many developing markets presents additional risks. Within the U.S., higher growth technology sectors may benefit as trends in ecommerce, remote working, and digital engagement are strengthened due to the unique circumstances of the coronavirus crisis.
In sum, barbell investing may still work for active tactical investors, but longer-term strategic investors may want to focus more on opportunities in the center of the risk spectrum. So, put down the barbells and take out the kettlebells…
Investing in certain securities may help to hedge against certain risk but does not imply any guarantee from loss. There are no guarantees any investment or strategy will meet its intended objective.
Stay safe and stay healthy!