Bonds – what are they good for?
For intermediaries only
Introduction from Nick Dixon, Aegon’s Investment Director
This month, I am delivering you into the safe hands of Morningstar portfolio managers as they examine a subject I’ve had many a heated debate over lately, namely, what do bonds offer investors in today’s high inflation, low yield, and low interest rate environment?
Traditionally bonds have had two key roles in portfolios: 1) as a source of return, 2) to diversify equity risk and reduce volatility. Below, Mark Preskett, Portfolio Manager EMEA and Tanguy De Lauzon, Head of Asset Allocation EMEA at Morningstar tell us if either of these still holds true.
Fixed income market valuations
With seven goals and three assists last season, Liverpool’s James Milner is proof that today’s football manager expects more from their defenders than just keeping the ball out of their own net. Fixed-income markets have enjoyed one of the greatest 35-year bull markets in history. With 10-year government bond yields falling from highs of over 15% in the early 1980s to lows of around 1.25% nowadays, the asset class has delivered unprecedented outcomes for cautiously-minded investors on a risk-adjusted basis. In many ways, fixed income has been akin to the world’s greatest defence in a football team, with an ability to score goals (deliver returns) and never concede (rarely suffering downside risk).
Fixed income as a source of return
When comprehending the opportunity presented by fixed income at current levels, investors should focus on what is knowable and draw lessons from history. In this regard, we know from broad perspective that lower returns are expected and sensitivity to interest rates is elevated.
Lower return expectations tie into valuation. With low bond yields, valuations are considered at the outer bounds of normality. The prognosis from such a position is one of two viable scenarios. First, valuations could remain at the outer bounds of normality, where yields remain low. In this case, major declines from bond markets are unlikely, although the return backdrop is likely to be very modest due to the compressed starting yield. The alternative would be for valuations to revert towards their historical norm, where we would likely see negative returns followed by something closer to normality.
The greater sensitivity to interest rates is a result of duration. As inflation pressures have subsided, governments have been incentivised to lock in low rates for longer.
Source: Morningstar Investment Management Europe Ltd, figures gross over period from December 1998 to 30 September 2017. Past performance is no guide to future performance and the value of investments can go down as well as up.
This evolution has changed the maturity profile of the market and, has acted as a further tailwind to returns as the price of longer-dated bonds is more sensitive to interest rate changes. The point here is to acknowledge that market conditions matter, which leads us to a conversation about the role government bonds can have in a portfolio based in the current challenging landscape.
Diversification against an equity shock
It is useful to pause at this point and contemplate what a bond truly is – if held to maturity, it is an instrument that offers a capped upside (coupons) with an extremely low risk of default. However, the majority of investors don’t buy government bonds directly, and thus, need to consider the secondary market to understand how protective these assets will be during periods of stress.
Specifically, it is the ability to buy and sell in a secondary market where the diversification benefit is obtained. The theory is that when stocks go up, bonds go down; and vice versa. Yet, it is worth contemplating broader history because this can be grossly misleading over extended timeframes.
Source: Morningstar Investment Management Europe Ltd. IMF and Morningstar data over period from 31 January 1963 to 30 November 2016. Past performance is no guide to future performance and the value of investments can go down as well as up.
In the chart above, we can see the correlation between stocks and bonds over time. By charting the rolling five-year average, we look through the noise and can see a material difference in the average correlations between the late 1900s and the post-2000 era. While some may justify this by pointing to distinctly different inflationary pressures during each period, generalisations of this nature may not be representative of the future.
More dangerous, in our view, is to extrapolate the last 15 years of negative correlations and expect it to continue in perpetuity. This would ignore the current state of yields (in both nominal and real terms) and entrench an investor in ‘recency bias’ (our behavioural tendency to extrapolate recent trends).
Specifically, we want to go beyond generalisations and average correlations – instead focusing on the possibility for different types of equity shocks and how it might affect bond yields. A particular emphasis on the pre-1980 period could be useful in this regard, as rising interest rates had a meaningfully depressive impact on both equity and fixed-income returns. This must be respected as a potential scenario from current levels, with a recent uptick in inflation showing that this is indeed possible. In fact, by looking back through the 1963 to 1980 inflationary period we find that the average correlation between equities and bonds was mildly positive (averaging 0.21), however, bonds were still protective when they were needed (averaging an annual return of 3.1% during equity drawdowns.
Bringing this into a portfolio context
The above information helps us determine whether fixed income should play a role in a portfolio if it offers low return expectations. When equities sell off and diversification is needed, fixed income can indeed be useful as a true diversifier. Therefore, the lesson when sizing positions is to think holistically about the benefits and avoid the temptation to use average correlations.
It may be an onerous process, but by putting a lot of effort into understanding true diversification at a portfolio level, we can understand the intricacies of the exposure and ultimately our portfolio risk.
If we go back to the football analogy, we know that a well-constructed team requires a mix of strikers, midfielders, and defenders. Government bonds may not offer much by way of attack (poor long-term return prospects), but they have had an ability to hold up defensively when called upon (especially if equities sell off).
Yet, we also want to know whether we can rely on defenders that have put on weight (government bonds with long duration) and how these fit when many of the attackers are slowing of old age (equities with stretched valuations). Ultimately, a great defensive line up can be as effective as a great attack, but the key is to consider the opportunity set holistically and not rely on any one player.
Morningstar Investment Management Europe Ltd is the lead consultant for Aegon’s Core and Select Portfolios. To find out more about these portfolios please speak to your usual Aegon contact or visit our website.
The value of investments may go down as well as up and investors may get back less than they invest. This article is based on Morningstar’s understanding of the current and historical position of the markets and shouldn’t be interpreted as recommendations or advice. Past performance is not a reliable indicator of future results.