Investors have been cautioned not to worry about a possible rotation or asset shift from bond portfolios into equities, but rather look to mitigate "hidden risks" in portfolios.
The BlackRock Investment Institute (BII) report, Forget Rotation: Think Risk Mitigation, was released following global chief investment strategist Russ Koesterich's recent visit to Australia, and claims there are "major holes" in the great rotation theory.
For example, a resumption of robust global growth that would justify a strong move back into stocks is by no means certain. This theory also assumes that strong inflows into bond funds since early 2009 came from stocks - and will now return there. But in fact, these flows more likely came from money market funds, BII stated.
Of more pressing concern are the inherent risks lurking in many fixed income portfolios, according to BII, which said the bottom line is that interest rate risk in fixed income remains acute, and portfolio mitigation measures are in order.
The 'doomsday' era appears to have run its course, potentially favouring riskier assets, "but with muted and regionally disparate economic growth, the foundation for a sustained risk rally looks shaky," the report stated.
BII said bond portfolios carry fewer diversification benefits and more risk than in the past, and more risk than many investors realise.
"Rather than worry about the bursting of a bond bubble and/or salivate over a massive shift to equities, investors would do well to focus on these hidden risks," BII advised.
Fixed income portfolios can no longer be regarded as a safety cushion. Investors are hunting for yield in an environment with historically low yields available, which is compressing spreads on many credit instruments to record lows, the paper said.
"Ultra low yields mean safety cushions - to what extent a bond's income offsets a price fall due to a rise in yield - have turned into beds of nails," the paper said.
For example a 17-basis point uptick in the 10-year US Treasury yield would wipe out a year's worth of income.
BII recommended investors first aim to recognise what the hidden risks in their fixed income portfolios are, and consider diverging from or even abandoning fixed income benchmarks.
Investors should also shorten their duration and emphasise higher yielding credit over 'safe' government bonds, and be ready to rotate duration, credit sectors or asset classes because markets tend to overshoot.
For bonds, investors should focus on income and not count on capital gains in bond sectors that have had a great run, such as US municipal bonds, which should be bought for income only.
Investors should also be prepared to sacrifice a bit of yield in order to purchase higher quality assets, and look at options to protect against downside risks or participate in upside opportunities that are currently cheap.
BII also recommended reducing market exposure by buying favoured assets and simultaneously selling short, similar but less desirable securities.
