Alain Forclaz, deputy chief investment officer of Lombard Odier Investment Managers’ multi-asset team, argues bonds still have a role to play in investors’ portfolios, with so few genuine portfolio diversifiers available.
Bonds have been a highly attractive asset class for the past 30 years, providing consistent income and protecting portfolios when recessions hit.
Yet this dynamic has now seemingly reversed, with bond yields low, or even negative – around $13tn (£9.4tn) of bonds have a negative yield, meaning you are effectively paying to own it.
Central banks are still following an easing monetary policy and governments have embarked on vast fiscal stimulus programs, raising hopes for a rebound in economic growth but stoking fears of a return of inflation. Hence, ‘risk-free interest’ as highly rated sovereign bonds have been known, has become ‘interest-free risk’ as some have coined it.
Against this backdrop, two questions have risen to the top of investors’ mind: Firstly, are bonds still useful in portfolios, continuing to provide protection and if not, where else can investors turn? And secondly, how do shifting bond market dynamics affect other asset classes, in particular relative to equities?
First off, let us remember that 12 months ago, yields were about where they are today. During the Covid shock of February/March 2020, bonds did protect portfolios, albeit unevenly and to a lesser extent than in the past, eg in the financial crisis of 2008. For example, Swiss or Japanese government bonds provided no protection at the height of the pandemic shock. They displayed ‘positive correlation’ -their returns were correlated or moved in the same direction as equities- and negative performance that did not offset the negative return of equities.
On the other hand, US bonds, despite a short initial sell-off, did offer some protection, providing negative correlation to equities and positive performance. So, an outright removal of sovereign bonds from portfolios seems too extreme, in our view. What is clear, though, is that the breadth and depth of the protection have diminished.
So where can investors turn for diversification? There are fortunately a few answers.
Within traditional sovereign bonds to begin with, looking further afield may prove useful. Chinese sovereign bonds for example, had both positive performance and negative correlation to equities during the Covid shock.
Inflation-linked bonds may have a more important role to play going forward, mixing a sensitivity to ‘duration’, or interest rate risk, with some inflation protection.
Another example is foreign exchange as an asset class, with the Japanese yen or the Swiss franc traditionally seen as safe havens, which can be gained through direct exposure to short-dated foreign bonds.
Gold is a popular safe haven and a traditional inflation hedge, too, although its performance during last year’s shock failed both in terms of correlation to equities (positive) and overall performance (negative).
This frantic search for diversification has also led to the development of a number of so-called ‘defensive strategies’, some using systematic trading designed to protect against equity shocks or other events, for instance a rise in bond yields.
Examples include buying the VIX index, known as the ‘fear index’, or capitalising on the tendency of markets to move in trends. This can be on a long-term basis or, in an increasingly popular format, short-term (intra-day) basis. These types of strategies performed very well last year, with performance ranging from the mid-teens to 40-50% over the Covid shock.
Finally, cash as a protective asset, used tactically, remains an underutilised option, even though it obviously fits the bill with the additional advantage of its simplicity. However, it must be noted that most of these options will themselves lose small amounts of money. For example, with cash rates so low, the value of money on deposit is being eroded by inflation.
Perhaps combining a comfortable yield and a solid diversification potential in a single asset is a thing of the past!
Diversification within equity sectors
With the US Federal Reserve now expecting interest rates to start rising in 2022, investors have started to analyse the sensitivity of their portfolio to rising rates, in particular their equity portfolio.
Historically, the sensitivity of equities to interest rates has varied through time, but recently growth stocks have become increasingly negatively sensitive to rates, with tech stocks selling off on fears of rates rising. At the same time, ‘value’ stocks’ display the opposite behaviour.
So the rate sensitivity of an equity portfolio overall may largely depend on its specific exposure to the value and growth sectors.
More generally, if we look at a broader set of equity factors or styles, a similar analysis shows that quality and size currently have a positive rates sensitivity, similar to value above, whereas momentum has a negative sensitivity, like growth.
A finer analysis at sector level sheds an interesting light, with financials, industrials, materials or energy having positive sensitivity to rates. These could potentially be able to offset the negative sensitivity of utilities, telecommunication services, IT and consumer sectors.
In short, it does appear that the sensitivity of equity portfolios to rate movements has accelerated since early 2020. A rotation towards value might be explained in part by a desire to position favourably against a rise in bond yields.
More generally, in our view, allocation to individual sectors can potentially reduce this exposure, but this requires an active, rather than passive, approach, and as a whole, the S&P 500 index has negative sensitivity currently due to its growth bias.