Multi-Asset Insights: Are bonds still an effective hedge against growth-sensitive assets?
A combination of low bond yields, the risk of a Federal Reserve (Fed) policy mistake and the market environment over the summer has raised concerns over whether bonds still have the “hedging power” for growth portfolios.
Throughout this piece, we use a growth proxy defined as 67% MSCI World Local, 33% GBP 3M Libor to represent a growth portfolio.
Measuring hedging power
The classic method for understanding hedging power is correlation. If the correlation between two assets (A1 and A2) is negative then we would expect a portfolio holding A1 to be able to hedge by allocating to A2.
However, as the correlation between the two assets becomes less negative, the benefits from hedging the A1 portfolio with A2 fall.
Furthermore, in previous research, we had identified the need to look beyond correlation and to include volatility to look at magnitude as well as direction.
Therefore, expanding our research to downside beta, we observe that the negative downside beta observed between US Treasuries and our growth proxy has been reducing over recent years.
This poses a real challenge for investors, as it potentially makes portfolios more susceptible to growth shocks.
To test if diversification has indeed been worsening, we calculated realised efficient frontiers for a range of equity bond portfolios (bonds ranging from zero to 40% allocation) over one year rolling periods back to 1992.
The stronger the hedging power, the higher the risk/return benefits of including bonds as shown by a positive slope on the efficient frontier.
Looking at this measure, shown in Figure 1, we see that the diversification benefit of bonds has indeed been diminishing in recent years, but the level remains around the long-term average.
This measure helps us to understand if bonds’ hedging power has deteriorated, but it should not be considered a forecast for reduced hedging power going forward.
Dynamics across the curve
Having established that bonds may now be less capable of hedging growth risk, we now look to see whether the effectiveness of bond hedging is dependent on curve positioning.
Looking at the downside beta of yields across the curve, we observe that the traditional bond hedging instruments, 10 year maturities, are less effective than 5 years – that is that they have a higher negative downside beta.
For portfolios that cannot take leverage, the 30 year bond’s higher duration has the best hedging capabilities.
A portfolio that can take leverage would seek leveraged exposure to the very short end of the curve which has the highest negative downside beta to growth assets and has actually been improving (moving more negative) in recent years.
Dynamics across the distribution
Even though their hedging power has reduced, bonds are still helping to protect balanced portfolios during equity sell-offs.
While as equities sell off, bonds perform well, when bonds underperform, equities also perform poorly – a noticeable feature since the taper tantrum.
One way to rationalise this is that bonds are still hedging growth risk, but bonds and equities are also loading on additional risks (possibly related to liquidity tightening or inflation) and these risks are becoming an important contributor to equity/bond correlation.
As the correlation conditional on bond sell-off is most pronounced at the long end of the curve, as explained above, it may be that this risk is related to inflation rather than liquidity.
This suggests an additional way to hedge equities could be Treasury Inflation Protected Securities (TIPS) breakevens.
This should be investigated further, particularly given their rather attractive current valuations.
Having undertaken further research on this topic, one of our key conclusions is that relative liquidity, here defined as central bank liquidity over private sector liquidity, has been a more effective tool in supporting inflation expectations.
Therefore, an effective hedge against growth-sensitive assets could be expressed through FX as a risk premium rather than interest rates.
Consistent with our initial thoughts, we find the hedging power of bonds has been reducing, despite a reasonable negative downside correlation with equities still existing.
However, it is clear that risks other than growth appear to be affecting equity and bond correlation dynamics.
Since these effects are most visible at the longer end of the curve, we suggest that inflation expectations are key drivers of correlation dynamics.
Excluding recessionary periods, given that US CPI is at its lowest for over 50 years, there are many ways in which higher inflation in the future could affect bonds’ ability to act as a growth hedge.
Therefore, at this stage, we suggest that portfolios with the ability to take leverage could hedge growth risk by positioning at the short end of the curve and leveraging up to increase duration.
However, portfolios that cannot take leverage may wish to diversify their hedging implementation by considering TIPS breakevens and/or safe haven currencies
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