Bond and multi asset managers are warning investors that the traditional downside protection offered by government bonds is decreasing rapidly in an environment in which bond yields remain at record lows.
Traditionally, fixed income has been a diversifying asset that typically performs well when risk markets, such as equities, sell off.
Given the size and magnitude of the two sell offs seen in March and September last year; many will, unsurprisingly, have looked to government bonds as a source of protection.
But is this model broken?
Diversification priority
“In the first quarter of 2020 the main German stock index fell 25%, but German bunds only rose 2%,” said Arif Husain, portfolio manager of the T. Rowe Price Dynamic Global Bond Fund.
“This indicates the diversification power of bonds may be much less potent in the current low interest rate environment.”
If this is the case, Husain said that it follows that government bonds should no longer be the sole risk mitigation tool and that finding new sources of diversification should be “a priority” for investors in 2021.
“This will require a portfolio construction that is more agile and uses relative value positioning, volatility trading-based instruments, and in-depth research to benefit from potential decorrelated opportunities,” he added.
Shrunken potential
So, where are these new sources of diversification and so-called decorrelated opportunities?
Asbjørn Trolle Hansen, head of Nordea’s Multi Assets Team, said that with fixed income’s diversification potential being “significantly decreased” at current interest rate levels, there is a strong need for investors to have alternative tools available to be able to diversify equity beta risk within portfolios.
“This remains more pressing than ever, particularly as the traditional diversification potential that investors have been used to in the past shrunk even more significantly in 2020,” he said.
“The sharp equity market sell offs investors had to experience in March and September 2020 have been a strong testimony of this dilemma investors are facing – for example, duration versus equity beta.”
As result, Hansen stressed the importance of having proprietary alternative defensive strategies in the toolbox that can help investors to fight that dilemma and achieve diversification within their portfolios.
“One example is the use of defensive currencies being selected based on quality characteristics and attractive valuation that can serve to achieve the desired diversification effect,” he said.
“So, now more than ever, investors must focus on diversification and find investment solutions that can rebalance and enhance risk adjusted portfolio returns – since most of the traditional diversification potential has faded away,” he added.
“While we have been claiming that diversification has been at risk for some years now across traditional asset classes, 2020 has proven us right.”
Shedding pounds
Even with global sovereign bonds hovering around record lows, Chris Metcalfe, investment and managing director at Iboss, does believe diversification benefits remain from holding them.
However, that has not stopped him from cutting his weighting to them.
“In an equity-driven risk asset sell off, gilts and treasuries can dampen down volatility,” he said. “The real question for us is that outside of limiting drawdowns, can a good investment can be made? Here we are less convinced.”
As such, based on their valuations and the underlying macroeconomic backdrop, Metcalfe said Iboss has just reduced its gilt and treasury positions within its portfolios.
“The potentially inflationary fiscal policies of the […] Biden/Yellen administration combined with a super dovish Fed means the potential for another taper tantrum has never been higher,” he said.
“The inflationary effects of handing people cash could take months or even years, but then we invest on a three-to-five year outlook, not a couple of quarters.”
Metcalfe added that value is equally limited in much of the corporate bond space – especially high yield and its portfolio positioning reflects this.
“We have higher credit qualities and lower durations than we have had at any point in the last 12 years,” he said.
“There seems to be the perception in the markets that bonds won’t produce capital losses, and that cash is not a real investment. We would caution though that there will be a time when minimal returns – as delivered by cash – might not seem like such a bad outcome.
Quality diversification
While the bull market for equities may have further to run, Lloyd Harris, head of fixed income at Premier Miton Investors, believes there is now much less to play for in risk assets.
In such conditions, he argues high-quality corporate bonds provide something genuinely different to holding equities.
“Since March last year many investors have found that their bond funds have been quite correlated to the performance of equities and this is something we seek to avoid,” Harris said,
“With quality comes diversification,” he added. “The less credit risk in a fund, the less it is likely to behave like equities.”
