In part six of our seven-part video series on asset allocation, Kevin Barr. Head of SEI's Investment Management Unit and Jim Smigiel, SEI's Chief Investment Officer, discuss credit markets, specifically high yield and emerging market debt.

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Transcript

Kevin Barr - Hi, I'm Kevin Barr. Head of SEI's Investment Management Unit. Welcome to the sixth video in our Asset Allocation Series. Today we'll be talking about credit markets, specifically high yield and emerging market debt. I'm again joined by Jim Smigiel, SEI's Chief Investment Officer.

Jim, thanks for joining me today. Can you start off by describing the high yield and emerging market debt markets for us?

Jim Smigiel - Yes I can, thanks Kevin. We would typically view these as higher octane segments of the credit markets as compared to say investment grade corporates as they can offer a higher potential return but with higher potential risks. They also tend to carry more default risk, meaning there's a higher probability of the issuers not repaying their entire obligations, whether principal or interest. In the case of emerging market debt, there's also a large portion of the market that is denominated in the issuer's local currency. So for those bonds, even if they don't default, the value of interest and principal payments made to investors could be reduced if the payments are made in a currency that has depreciated. In general, we expect high yield and emerging market bonds to be riskier than investment grade credit. The good news of course, is that they typically may offer higher expected returns as compensation for this risk.

Kevin Barr - So can you elaborate on that a little bit more? Specifically when investors think about fixed income investments, most of us tend to think of them as low risk, low return.

Jim Smigiel - In fact that's true. And we actually think it's more appropriate to think of high yield and emerging market debt as hybrid asset classes that have the characteristics of both stocks and bonds. It's true that they typically offer a fixed interest payments and have established maturity dates. So they resemble traditional fixed income in that way, but they also behave like equities in some meaningful ways. A lot of the return investors earn through these asset classes depends on whether the issuer's default or in the case of local currency, emerging market debt whether the currency appreciates or depreciates. So those outcomes primarily depend on broader macro economic growth backdrops. Namely, whether global economies are strong enough that companies and governments are able to honor their obligations in full. These are a lot of the same factors that drive equity performance like stocks, high yield and emerging market debt tend to perform well when global earnings and gross domestic product are both growing at strong rates. This is born out in the data as well. Historically speaking, returns for high yield and emerging market debt correlate with equities at least as high and generally more highly as they do with investment grade bonds.

Kevin Barr - Now we seem to have some meaningful implications when allocating to these assets in a broader portfolio.

Jim Smigiel - Certainly does. And at a high level it means that not all so-called fixed income asset classes are interchangeable. You can see this on the chart which illustrates volatility as a measure of risk. If you start with a portfolio of 60% stocks and 40% investment grade bonds, and then you replace half of that 40% with high yield and emerging market debt you have just meaningfully changed the risk profile of your portfolio. It's now going to look noticeably riskier by about 15% than the traditional 60, 40 portfolio that you started with. That's not to say that high yield and emerging market debt can't or shouldn't be included in a diversified portfolio. We believe they do offer characteristics that cannot be perfectly replicated by simply blending global stocks and investment grade bonds. We also think it's necessary to be thoughtful about how we allocate to these hybrid asset classes and which exposures we use as funding sources for these allocations. This is one of the reasons that we feel that characterizing a portfolio strictly based on it's split between stocks and bonds is highly misleading. It's important to understand the compositions of those stocks and bond sleeves, the risks that they may impose on investors and how they will likely interact once combined in the broader portfolio. In my 60, 40 example, if you want to allocate 10% to high yield and 10% to emerging market debt you might need to fund half of it from investment grade bonds and the other half from equities in order to maintain a similar risk level to the traditional 60, 40 portfolio. The optics will be different since this portfolio would now hold 50% in what appears to be fixed income securities. But if you look more closely, the risk profile would be very similar. The result is a more diversified portfolio designed to help deliver higher returns at a similar level of risk. This is why we think it's incredibly important to look under the surface and identify the true sources of risk in the portfolio. The basic stock versus bonds proportions can provide a very misleading message.

Kevin Barr - Thanks Jim. Our clients depend on us to understand the risks and opportunities they face as investors. And it's helpful for us to see the level of thought and care that goes into constructing our portfolios. For the final video in this series, we'll go beyond our asset allocation philosophy and talk about the practical realities of owning a well-diversified portfolio. Thanks again for your attention.

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Index Definitions

  • The Bloomberg Barclays U.S. Aggregate Bond Index is a benchmark index composed of U.S. securities in Treasury, Government-Related, Corporate, and Securitized sectors. It includes securities that are of investment-grade quality or better, have at least one year to maturity, and have an outstanding par value of at least $250 million.
  • The ICE BofA U.S. High Yield Index tracks the performance of below-investment-grade, U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.
  • The JPMorgan EMBI Global Diversified Index tracks the performance of external debt instruments (including U.S. dollar-denominated and other external-currency-denominated Brady bonds, loans, eurobonds and local-market instruments) in the emerging markets.
  • The JPMorgan GBI-EM Global Diversified Index tracks the performance of debt instruments issued in domestic currencies by emerging-market governments.
  • The MSCI World Index is a free float-adjusted market-capitalization-weighted index that is designed to measure the equity-market performance of developed markets. The Index consists of the following 23 developed-market country indexes: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the U.K. and the U.S.

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Important Information

The information contained herein is for general and educational information purposes only and is not intended to constitute legal, tax, accounting, securities, research or investment advice regarding the Strategies or any security in particular, nor an opinion regarding the appropriateness of any investment. This information should not be construed as a recommendation to purchase or sell a security, derivative or futures contract. You should not act or rely on the information contained herein without obtaining specific legal, tax, accounting and investment advice from an investment professional. This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results.

Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Bonds and bond funds will decrease in value as interest rates rise. High yield bonds involve greater risks of default or downgrade and are more volatile than investment grade securities, due to the speculative nature of their investments.

Diversification does not ensure a profit or guarantee against a loss. Asset allocation may not protect against market risk. There are risks involved with investing, including loss of principal.

Information provided by SEI Investments Management Corporation, a wholly owned subsidiary of SEI Investments Company (SEI).