With interest rates at zero in many developed markets and a less stable correlation between equities and bonds, the Schroders multi asset team argues that government bonds will no longer provide the cushion in a portfolio that they once did.
Lesley-Ann Morgan, head of multi-asset strategy at Schroders, said the zero interest environment is leading the team to reassess the roles that conventional asset play within their multi-asset portfolios and if they need to look elsewhere to meet their return objectives.
“Short-term US government bonds now yield around zero,” she said. “Not only does this impact returns, but it meaningfully raises the cost of buying the US dollar, either for hedging or return-generating.”
For Morgan, the main problem is the evaporation of yield from cash and bonds.
“For some investors targeting a specific return, such as defined benefit plans and endowments and foundations, this expected reduction in returns that affects all liquid asset classes will make achieving their target significantly more difficult,” she said.
Not easy to replace
Given that in the past bonds have demonstrated a persistently negative correlation with risk assets, Morgan said they have traditionally played a role of protecting portfolios in the event of a growth shock impacting equities.
“However, we expect this relationship to be less stable and therefore less reliable as a hedge in a zero interest rate world with the lack of an interest rate cycle,” she added.
So is there anything that can adequately replace bonds in a portfolio? Morgan is doubtful.
“Cash clearly provides protection in the sense that it is unlikely to fall in value in the environments when equities fall,” she said. “However, cash rates are currently at historic lows and in periods where inflation is above the cash rate, cash is expected to deliver negative real returns.”
She added: “For investors who require liquidity, we believe the answer is highly dependent on risk appetite. Some will have no choice whether to hold bonds. But for others we believe the portfolio can be made to work harder through the use of liquid alternatives, thematic investing and greater use of stock selection.”
So, depending on risk appetite, Morgan said investors either need to accept lower overall returns, or seek to diversify within the return generating and risk-reducing parts of the portfolio separately.
