The Zhitong Finance App learned that Schroder Investment published an article saying that this summer, the Bank of Japan raised the benchmark interest rate to 0.25% at the end of July 2024, making the financial market tense and uneasy. In particular, it triggered a domino effect in the stock and fixed income markets. Subsequently, the S&P 500 Panic Index (VIX) soared to the third-highest record in history. Therefore, diversification from traditional sources of income, such as credit and high-yield dividends, is necessary to effectively supplement existing income streams during the economic cycle. Investment-grade corporate bonds and high-yield bonds are traditionally viewed as the cornerstone of income portfolios. Convertible bonds, securitized credit, and insurance-linked securities are other alternative sources of income worth considering for investors. From a multi-asset investment perspective, these asset classes are optimistic because they are less correlated with stocks and fixed income, and have the potential to provide attractive levels of return and increase risk-adjusted returns.

In an investment environment with high inflation and high interest rates, the correlation between bonds and stocks is still high. As investors consider how to reap returns, they should reassess the role of traditional bonds as risk diversification tools in their portfolios. Fixed-income investments do bring benefits, but interest rate risk goes both ways.

Traditional sources of income

Schroder believes that investment-grade corporate bonds and high-yield bonds are traditionally viewed as the cornerstone of income portfolios.

Among high-yield bond categories, a huge number of debts have been issued in the past few years, some of which will expire in 2025, so refinancing is required. In an environment of long-term high interest rates, financing costs will be higher. Therefore, investors should pay special attention to potential refinancing risks.

At the same time, the credit spreads on investment-grade corporate bonds are very small, and the valuation is still expensive (currently around 20%). In this context, diversification and alternative revenue streams continue to be sought.

How do other sources of income fit into the investment portfolio?

Convertible bonds, securitized credit, and insurance-linked securities are other alternative sources of income worth considering for investors. From a multi-asset investment perspective, these asset classes are optimistic because they are less correlated with stocks and fixed income, and have the potential to provide attractive levels of return and increase risk-adjusted returns.

Convertible bonds: Considering that interest rates are declining, convertible bonds can capture attractive upward potential. Compared to direct investment in stocks, convertible bonds provide a flexible option and have less downside risk. The issuers of convertible bonds are usually medium-sized companies that can benefit from a reduced interest rate environment.

Securitized credit: This type of asset accounts for the majority of the US bond market and can provide diversified income, so it can be used as an alternative to traditional corporate bonds. Securitized credit provides a different driver than traditional credit and relates to cash flow from consumers, homes, and other physical assets. Compared to US investment-grade bonds, it can increase yield and credit quality while reducing longevity.

Insurance-linked securities: These assets are designed to transfer insurance risk from insurers to capital market participants, and have limited or no correlation with traditional stocks and fixed income. The return is based on factors such as the frequency and severity of natural disasters, which can result in insured losses, such as earthquakes and hurricanes in peak areas with high insurance coverage.

Insurance-linked securities (ILS) provide risk-adjusted returns and are less relevant to macroeconomics and traditional assets. A common type of insurance-linked securities is a cataclysm bond (cat bond).

The impact of climate change on insurance-linked securities

Climate change will increasingly lead to growing demand for insurance coverage, which poses a threat but also brings investment opportunities. However, climate change is a gradual long-term phenomenon, and typical insurance-linked securities are short-term investment products.

Furthermore, when considering the climate change process, only weather-related insurance risks are affected. Other natural disaster risks such as earthquakes (a key driver of risk at the bottom of the entire insurance-linked securities market) are unaffected.

As long as potential risk models properly reflect the increased level of risk associated with these trends and the risk is properly hedged, the broader trend will still provide attractive investment opportunities for investors in insurance-linked securities.