When bonds go bad….and what to do about it (part 4: asset allocation)
As my colleagues have described in previous blogs, the performance prospects for traditional government bonds look bleak. Low starting yields mean potential returns are low; even in the case of an economic shock, we believe there is limited space for bond yields to fall further. In 2020, in the face of the worst economic recession in centuries, the European Central Bank did not cut rates and in the UK gilt yields fell by only 0.6%.
The efficacy of bonds as a safe-haven asset class in risk-off periods is now heavily compromised, in our view. Indeed, recent months have shown an increasingly worrying pattern of bond yields rising on days when equities are falling, rather than the other way round. Holding duration in your portfolio hasn’t helped when you need it most.
Lower expected returns extend to credit and equities too, although in the case of equities we don’t think rising yields would necessarily be damaging. John Southall has looked at the behavioural aspects of responding to lower real yields, but what practical steps could asset allocators consider to counter the increasingly obsolete role of bonds?
We believe there is no silver-bullet solution to this problem. Rather, a combination of different strategies can in our view act in harmony either to support portfolios when equities fall or to provide the return that bonds have done in the past.
As multi-asset investors, our go-to response to any portfolio challenge is to increase diversification, looking for more and varied return streams from the available investment universe to help smooth portfolio returns. Where we do continue to hold government bonds, we want to seek higher yields from steeper yield curves, as we believe these yield curves still have some propensity to compress if the world faces a new economic downturn. Examples could include Australian and Chinese bond markets.
Where possible, options can play an obvious and predictable role in protecting portfolios from equity drawdowns. However, we would hasten to add that it can be all too easy to overspend on option protection, especially as equity volatility remains elevated compared with the majority of the previous decade, so budgeting is important. Some would also regard cash as offering increased option value in these environments too.
Defensive currencies such as the Japanese yen and Swiss franc play in increasingly important function in our portfolios. The unwinding of carry trades made these currencies rise in previous risk-off episodes and, while narrower interest-rate differentials now make those carry trades less prevalent, we still believe some structural and behavioural drivers will push these currencies higher in risk-off moments.
Intriguingly, we now believe that exposure to inflation-linked assets should be reduced or hedged. In fact, short exposure to inflation may benefit portfolios as a global economic shock would most likely see both equities and inflation falling, so this position could act to offset losses.
So those are five ideas for risk mitigation without relying on bonds. But what about return replacement options?
We can start by extending credit risk into areas that still offer some compensation, such as emerging-market debt. Distinct from higher credit risk would be a move to less liquid, but still highly rated assets, where investors can earn an illiquidity premium. This could include quasi-sovereign and sub-sovereign debt such as regional governments.
Outside fixed income, equities with stable cashflows like property or infrastructure may look increasingly attractive as the yield gap has continued to widen, but of course the overall risk profile of investments is now starting to change more significantly. A different tack would be an increased allocation to more alternative risk premia such as value, carry and momentum, with a range of systematic strategies designed either to generate differentiated returns or some specifically aiming to deliver returns in periods of high equity volatility.
An additional approach would be to tackle the problem through targeted risk management, either by minimising or excluding assets exposed to thematic risks, or by increasing the allocations to assets that would benefit under certain risk scenarios. While this thematic approach may prove effective, we believe that grey swans are all too common and so a degree of structural risk management remains important.
A final thought is that as the nominal return expectations from traditional assets has declined, we believe target-return approaches that maintain their return target with stable risk characteristics have become relatively more attractive. Dynamic target-return approaches to asset allocation should be able to pursue most of the possible solutions presented above, but we believe each investor should consider the options available in their investment universe to confront the increasingly challenged position of bonds in their portfolios.