Many in retirement are travelling comfortably, with three key factors contributing to their happiness – good physical and mental health and enough money to enjoy life.
Perhaps the assumption that markets are still anchored by predictable economic policies needs to be challenged. For the first time since the fall of the Berlin Wall, political volatility – once background noise – is potentially reshaping investment risk at a structural level.
Are bonds the biggest risk in your portfolio?
Whilst listening to a recent conference by a global multi-asset manager, or “balanced fund.” for lack of a better term, it became evident that most portfolios are inadequately prepared for the future that lies ahead.
The group has a number of less-than-conventional views on the asset markets, but it wasn’t these that piqued my interest, rather it was an innocuous slide that measured the correlation benefits of holding traditional government bonds at current valuations. Before moving into the specifics, it is important to understand the background, being that almost all capital invested around the world is managed using a traditional ‘balanced’ approach. Under this approach, which is grounded in academic research, an allocation to low-risk government bonds is “always” appropriate for portfolios and can be as high as 40 per cent of the amount invested, with equities tending to make up the remaining 60 per cent.
The premise of this allocation to government bonds is that they offer (or once offered) three benefits to investors: consistent income, capital stability and correlation benefits. At this point, the focus is on the latter, which has become increasingly important in an environment where calls of equity market bubbles lead almost every news headline. Historically, with March 2020 a perfect example, when equities markets fall significantly, by say 10 per cent, the lower-risk government bond portion outperforms, offsetting the loss of value in the equity component. This is due to the “flight to safety” factor, with greater demand for a limited amount of bonds sending their prices higher.
Today, there is little room left to move. Quantitative easing and so-called money-printing policies have fixed short-term interest rates near zero, with central bank buying of government bonds doing the same for the 10-year bonds as they have for short-term rates. The basic relationship between bond values and rates is simple: as interest rates fall, existing bonds become more valuable because they yield more. It should be no surprise, then, that government bond yields have never been lower and as a result their valuations have never been higher.
Are correlation benefits extinct?
The slide showed how the simple relationship between bonds and equities has clearly been broken. As it stands at the beginning of 2021, the yield on US government bonds would need to fall from 0.9% today to negative 0.6% in order to offset a 10 per cent fall in the equity portion of portfolios. It doesn’t get much better in Europe, with the yield needing to fall from negative 0.6% to negative 2.0%.
Retaining a significant exposure to traditional, long-duration government bonds is effectively betting that they will protect your portfolio in the event of another sell-off. This is because they offer little in the way of income, and therefore, would only be included on the basis of their expected correlation benefits. Yet to offer any correlation benefits they must fall further into negative-yielding territory; this is clearly speculation, and is unlikely to be a prudent portfolio management strategy.
While the calls of a great year for markets grows louder, now is clearly not the time to be sticking with the status quo.
