Lazard Insights

Searching for Stable Income in

Volatile Markets
Dr. Benjamin H. Dietrich, Director, Portfolio Manager/Analyst

Investing for income, which once meant earning a reliable income

Summary
• With global yields still close to their historic
bottom and jittery markets anticipating resurgent
inflation, we believe investors should no longer
count on returns on “risk-free” income keeping
pace with rising prices.
• Diversification with global exposures across
fixed income sectors provides an essential
foundation for withstanding and ultimately
prospering in the challenging current
environment, in our view.
• We believe an effective income strategy
requires active management to uncover the
pockets of value in a far-flung $50 trillion-plus
market that will optimize diversification in an
income portfolio.
from dependable assets, has become a risky business. The yield
from Treasury securities, once the standard of reliability, has dried
up at shorter maturities. And to judge from the view expressed by
the forward US Treasury curve, the yield drought looks set to drag
on with little relief in sight. Current forwards pricing concurs
with Federal Reserve projections of two rate hikes at most over the
next two years (Exhibit 1).
Exhibit 1
Low for Longer
US Treasury Active Yield Curves
(%)
3

2-Year Forward
Lazard Insights is an ongoing series designed to share value-
added insights from Lazard’s thought leaders around the 2
world and is not specific to any Lazard product or service.
This paper is published in conjunction with a presentation
featuring the author. The original recording can be accessed 1
via www.lazardassetmanagement.com/insights.
Spot

0
1 2 3 6 9 1 2 3 4 5 7 9 10 12 15 20 30 50
Mo Mo Mo Mo Mo Yr Yr Yr Yr Yr Yr Yr Yr Yr Yr Yr Yr Yr

As of 23 February 2021
Source: Lazard, Bloomberg

Regardless of what government stimulus and the Fed’s
determination to pin down rates bode for the health of the real
economy, the two policies working together could well reanimate
long-dormant inflation. More dynamic inflation would erode
the value of static Treasury coupon payments, a prospect that
has already unnerved the market, prompting volatile selling and
reducing the value of Treasury securities.
Principal in Peril
Yields not far from their historic nadir and jittery markets
anticipating resurgent inflation put income investors in a tight
spot—no way can they count on risk-free income keeping up with
rising prices. To derive any real income in a scenario of renewed
inflation, they will have no choice but to take on risk. They might
venture into dividend-paying stocks in a richly valued market or
into a concentrated exposure at the lower reaches of bond credit
ratings, but either choice could pose a significant threat to the
value of the underlying nest egg.
Yet if income investors can take on sensible risk and manage it
actively—and we believe they can—higher starting yields can have
a silver lining of higher prospective returns, as shown in Exhibit 2.
The X-axis indicates the current monthly yield of the global bond
index; the Y-axis represents subsequent returns in the next five
years. Plotting the monthly yields against their five-year returns
reveals a pronounced positive correlation.
Exhibit 2
Returns Follow Yields’ Lead
Five-Year Forward Return (%)
6
5
4 States
3 Source: Lazard, Bloomberg
y = 0.6252x + 2.4244
R² = 0.7285
2
2 3 4 5
Current Yield to Worst (%)
As of 26 February 2021
Period: 31 March 2000 – 26 February 2016
Source: Lazard, Bloomberg
2
Expanding the Fixed Income Universe
Risk and opportunity in fixed income play out in two dimensions:
credit and duration, a rather limited scope over which either to
diversify exposures or search for new possibilities. Extending a
portfolio beyond its home market by going global can add a third
dimension. Consider the third-dimension opportunity first.
Many blue-chip corporates issue debt in local currencies at varying
spreads to local sovereign debt to fund their local operations—
Toyota, for example, in Exhibit 3. Often, local market
idiosyncrasies and lingering inefficiencies in the global markets,
not credit quality, explain spread discrepancies across different
currencies. An actively managed global portfolio can identify such
anomalies and extract extra income from them.
Investing in a five-year Toyota bond in Norwegian kronor would
have gained almost 70 basis points (bps) in spread over investing
in the local sovereign bond, compared, for instance, to a spread
of only 20 bps over Australian dollars. Such harvesting of global
relative value can regularly deliver alpha.
Exhibit 3
It Pays to Travel
Five-year Toyota Bonds in respective currencies
(bps)
80
60
40
20
0
Australia Japan United United Europe Canada Norway
Kingdom
As of 23 February 2021
We believe that portfolios can efficiently and effectively hedge the
third dimension of risk in going global: currency risk. Over the
long run, the cost of hedging has not significantly altered risk-
adjusted fixed income returns. Leaving a modest portion of foreign
currency unhedged has not increased fixed income’s inherently
low volatility but has added to active management’s tool kit. In a
global benchmark context, by way of illustration, a 10% exposure
to foreign currencies would have left the investment’s volatility,
as measured by the standard deviation of its returns, essentially
unchanged at less than 3% (Exhibit 4).
 3

growth, which tends to result in spread tightening. A caveat is

Exhibit 4
Foreign Exchange: Little Risk at Low Levels
that this relationship may only hold in an environment in which
inflation is broadly subdued, as it has been for most of the last 20
Bloomberg Barclays Global Aggregate Hedged and Unhedged
years.
Standard Deviation
6 Nevertheless, the virtues of a global income portfolio diversified
across fixed income sectors, currencies, countries, and maturities
become obvious when measured against the performance of
4
dividend-yielding stocks. The model is projected to generate about
1.8 times more annual income than the current dividend yield of
2 the principal global stock benchmark, the MSCI World Index,
with about one-quarter the volatility, as measured by the annual
standard deviation of returns. In fact, discounting the yields by
0
0 10 20 30 40 50 60 70 80 90 100 the amount of risk taken, the MSCI World’s yield is negligible,
Open FX Allocation (%)
compared to the model portfolio’s 85 bps (Exhibit 6).
As of 29 January 2021
Source: Lazard, Bloomberg

Exhibit 5
World Class
Smart Money, Sensible Portfolios (%)
10
Venturing into the third dimension, the global dimension, can in
Effective Yield Standard Deviation
our view add the sensible diversification that an income portfolio 8
needs to serve its purpose in an uncertain and challenging fixed
6
income environment. To demonstrate that contention we devised
a model portfolio using equal-weighted indices as proxies for 4
actual positions. We sought yield enhancement through global
2
high yield, emerging markets corporate bonds, and local- and
dollar-denominated emerging markets government debt, and we 0
Global Global Global EM External EM Local EM
anchored the portfolio with developed markets government and Government Corporate High Yield Sovereigns Sovereigns Corporates
corporate bonds for stability. The portfolio hedges local currencies As of 23 February 2021
against the dollar, except for the locally denominated emerging USD Hedged Returns, except for EM Local Sovereigns
markets index, where open currency exposure represents a large Source: Lazard, ICE BofA, JPMorgan, MSCI

portion of total performance. (Exhibit 5).

As constructed, the relative lack of correlation among the
Exhibit 6
portfolio’s constituents adds to the diversification potential. Value Added, Volatility Subtracted
The average daily correlation of the indices to one another has
(%)
on occasion spiked as high as 0.8, close to the 1.0 that indicates 15
perfect harmonization, but the average of those averages has run Combined Fixed Income

less than half that mark, below 0.4, for the last decade. With MSCI World
10
constituent performance so relatively random, investors can expect
rallying sectors to regularly pick up the slack of the lagging sectors.
5
The inverse relationship between credit spreads and inflation is
another part of the explanation. Comparing the change in a blend
0
of BBB and BB US corporate spreads since September 2002 to the Yielda Standard Yield/Standard
Deviation Deviation
change in the monthly US Consumer Price Index, a measure of
As of 23 February 2021
inflation, yields a correlation of -0.32. Higher inflation, in other
USD Hedged Returns, except for EM Local Sovereigns
words, is associated with lower credit spreads. That makes sense a Yield is effective yield for fixed income and dividend yield for equities.
because higher inflation is often associated with higher economic Source: Lazard, ICE BofA, JPMorgan, MSCI
 4

A Call to “Active” Exhibit 7

Diversification Delivers
In sum, finding yield in a $50 trillion global market with a
portfolio anchored in the stability inherent in the fixed income Combined Fixed Income
asset class could well offer income investors the surest way out of Effective Yield (%) 3.16
the tight corner that market conditions have squeezed them into Average Historic Effective Yield (%) 4.52
(Exhibit 7). Effective Duration (Years) 6.08
Spread to Worst (bps) 215
As of 23 February, the effective yield of our model portfolio based
Number of Issues 14,750
on indices alone amounted to 3.16%, below its historical yield of
Market Value ($T) 49.34
4.52% but well above the 1.75% dividend yield of the equities in
Rating BBB/BBB+
the MSCI World Index. The portfolio has managed to generate
Annual Performance (10 Years) 4.40%
this yield while retaining investment grade quality, as measured
Standard Deviation (10 Years) 3.65%
by its spread to Treasuries, and staying within fixed income’s
fundamentally limited volatility. Sharpe Ratio (10 Years) 0.96

As of February 2021
The indices can reflect the characteristics and demonstrate the
The performance quoted represents past performance. Past performance does not
viability of a global income strategy in back tests and model guarantee future results.
Source: Lazard
portfolios, but we believe it requires active management to
optimize the strategy, especially in a time, as now, of elevated
uncertainty. Notwithstanding the Treasury market’s gyrations, a
market as vast and differentiated as global fixed income can offer a
wealth of relative value opportunities that wide-ranging, intensive,
and clear-eyed research can identify and profit from.

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Important Information
Originally published on 24 March 2021. Revised and republished on 25 March 2021.
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