Die another day - Why bonds are still important
One question we are regularly (and more frequently) being asked is whether bonds are still relevant in diversified portfolios. The basis of the question is well founded given low yields and the apparent asymmetric risks around them. We are not unsympathetic to this view. Our valuation models suggest bonds are expensive and when combined with the low level of yields, the mathematics dictate low returns from fixed income assets – unless of course yields continue to decline.
Portfolio construction though is somewhat more complex than this – requiring balance between what seems like the most plausible outcomes and the risks around them. After all, one thing we know with certainty is that the future is uncertain. This means that despite our best endeavours, markets are unlikely to unfold as per the script.
To declare our hand up front, we have been reducing duration in the Real Return Strategy as yields have declined. Maintaining a material duration exposure in the strategy has contributed significantly to performance over the last six months or so as bond yields declined on the back of sharp falls in energy prices, and an apparent soft patch in US growth (amongst other things). At the end of April, duration in the Real Return Strategy was around 0.9 years, down from 1.2 years at the end of 2014. While we anticipate reducing duration further, it is unlikely that we would avoid holding bonds and removing duration altogether despite low yields.
There are broadly two reasons for this:
Firstly, and perhaps most significantly, bonds (and duration in particular) are amongst the most effective hedges against deflation. While longer dated bond yields in Australia and the US look low on the basis of historic comparisons, the precedent from an extended period of moderate deflation in Japan, as well as the more recent flirtation with negative headline inflation rates in Europe, suggest there is significant scope for yields to decline given the right circumstances. While protracted deflation is not currently our “base case” for the global economy, the fragility of the global economy means it would not take much to see key economies fall back into recession, in which case deflation would then become a much more plausible outcome. The danger for investors is that markets would price this outlook pretty quickly. In other words what is currently say, a 25% probability outcome, would quickly become a “base case” scenario and yields that currently look low, would look attractive.
Secondly, valuations in many risk assets look extended (particularly US equities), while overall market volatility is low and investor complacency high. A significant correction in risk asset prices would likely favour bonds over equities. Even under circumstances where the correction in risk assets was bought about by rising interest rates and higher bond yields, bonds would likely outperform equities (as they did in 1994). It is worth bearing in mind that while current low yields and extended valuations make the risk of loss in bonds potentially higher than the risk of loss on equities, the potential downside for bonds, should such a period occur, is modest compared to that for equities. We recently examined the performance of US Treasuries against US equities in periods of severe dislocation in US equity prices (we defined this as a peak to trough decline in equities of more than 25%). In all these periods (11 in all since 1900) US 10-year bonds significantly outperformed US equities and in almost all cases posted positive returns during this drawdown phase. The caveat on this analysis is that current yields are lower than they were at the start of any of these phases. While this may weaken the argument, we don’t believe it invalidates it. Extending this analysis to periods where US equities declined by more than 10% produced similar results (bonds outperformed equities in all 22 periods in which US equities fell more than 10% and produced positive returns in 17 out of these 22 periods – 77% of the time).
A final point to make is that the “alternative” assets are not substitutes for the features of fixed income we see value in retaining – despite low yields. Investors are attracted to “alternative” assets in this environment due to factors such as higher yields, relative stability in capital values, and low or uncorrelated returns. This has meant that many of these assets have effectively become “leveraged” plays on the sharp decline in yields that has already occurred. Any unwinding of the prevailing low yield environment could well hit these strategies hard (infrastructure and property particularly). However from a risk mitigating standpoint they are likely to be relatively ineffective, and more likely actually compound risk in the portfolio as their correlations to risk assets rise, and liquidity deteriorates. Our own recent analysis comparing the performance of these strategies in risk off periods (we used the last four major dislocations in markets – 1994 rate hike, Asian Financial Crisis, Dot Com Bubble / Sept 11, Global Financial Crisis) also highlighted the significant outperformance of US bonds and poor absolute performance of most “alternative” strategies in these environments. The bottom line is that while alternative assets may have a place in a portfolio, their place is not as a substitute for the deflation and downside protection still offered by bonds in the extreme.
Overall though, our strategy is unchanged. We remain cautious – arguing capital preservation is critical in an environment of extended valuations and poor return prospects from most assets. Our high cash exposure is consistent with this and an important part of our medium term strategy. As asset valuations become more extended, there is increased optionality value in our cash holding, providing the flexibility to respond rapidly to repricing opportunities. One thing we are confident of though is that now is not the right time to be increasing risk in search of shorter term gains in “expected” returns.
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