Risk Parity: Reducing Our Bond Exposure

Every month, the portfolio management team for the Invesco Balanced-Risk Allocation strategy examines the market’s signals for stocks, bonds and commodities, and makes tactical adjustments in an effort to enhance returns. In recent weeks, our tactical signals for government bonds have led us to substantially reduce our exposure and adopt an underweight position.

How does the strategy work?

In a nutshell, our strategy seeks to be prepared for any economic environment by investing in three major asset classes1, and weighting them according to their risk contribution to the portfolio (not by dollar amounts):

  • Commodities have historically performed well in inflation-driven markets.
  • Stocks have outperformed in times of noninflationary growth.
  • Government bonds may provide a measure of defense against recessionary/deflationary periods.

Our strategic allocation balances the risk contribution of each asset class to the portfolio, based on historical risk and correlations as well as proprietary factors that we use as more forward-looking risk estimates. Our monthly tactical adjustments seek to take advantage of market cycles, allowing us to not only alter the targeted risk contribution in the strategy, but also the overall targeted level of risk. However, when setting the tactical risk allocation, we work within specified risk contribution ranges — each asset class may represent between 16% and 50% of the strategy’s risk level.

What are our tactical signals telling us now?

When making tactical adjustments to our bond allocation, we examine valuations, the economic environment and price trends. Recently, weakening price momentum, along with a rebound in commodity prices and slightly better economic data points, have dented the appeal for high-quality government bonds. In particular:

  • After the substantial drop in bond yields since the beginning of the year, all government bond markets used within the strategy are trading at very lofty levels based on our valuation framework.
  • After a sharp contraction in commodity prices since June 2014, particularly within the energy complex, prices have started to rebound, resulting in rising inflation expectations in the US.

At the same time, within the eurozone, consumer-price readings have stabilized at zero after falling into negative territory during the last few months. This development, along with somewhat firmer economic data points, has bolstered hopes that the European Central Bank’s bond buying program will lift economic growth and keep persistent deflation at bay.

Price trends have weakened as well, particularly during the last week of April.

These signals led us to reduce our risk exposure to bonds during our tactical adjustment process on May 1. We will undergo our next adjustment on June 1.

To learn more about my team’s approach, read my previous blog: Risk Parity: It’s About Preparation, Not Predications. You can also find more information on the fund page for Invesco Balanced-Risk Allocation Fund.

Important information

1 Under normal conditions, the strategy invests in derivatives and other financially linked instruments whose performance is expected to correspond to U.S. and international fixed income, equity and commodity markets. However, the performance of the asset classes cannot be guaranteed.

Diversification does not guarantee a profit nor eliminate the risk of loss.

Commodities may subject an investor to greater volatility than traditional securities such as stocks and bonds and can fluctuate significantly based on weather, political, tax, and other regulatory and market developments.

Obligations issued by US Government agencies and instrumentalities may receive varying levels of support from the government, which could affect the fund’s ability to recover should they default. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa.

Stock and other equity securities values fluctuate in response to activities specific to the company as well as general market, economic and political conditions.

The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC (Invesco PowerShares). Each entity is an indirect, wholly owned subsidiary of Invesco Ltd.All data provided by Invesco unless otherwise noted.

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