By Mike Dolan
LONDON- The days of using safe bonds as ballast for equity-heavy investment portfolios may now be numbered for many investors – though what replaces them is a much more complicated business.
As asset managers take stock at midyear of a shocking re-drawing of the investment map in 2020, one of the biggest question marks lies over the traditional role of government bonds in mixed-asset portfolios as a hedge against future equity slumps.
For all the sophistication of modern portfolio construction, the decades-old 60/40 equity-to-bonds idea has been a broad rule of thumb for many long-term institutional investors and individual savers – maximizing returns while keeping overall risk in check.
More volatile, higher-yielding equities outperform as the economy grows and safer government bonds do so in a slowdown or recession – gaining sharply in value during business and equity price slumps as official interest rates are slashed and fixed income in demand.
Worrying for those seeking diversification and hedges, returns on both have often risen in tandem over the past decade as slow growth and easy credit have buoyed all assets. But bonds have still typically proven as more than adequate offsetters during bouts of equity turbulence.
Until now that is.
The problem for many investors is the pandemic shock has finally sunken safe bond yields so close to zero that they have no where left to go performance-wise in another downturn over the next 5-10 years.
At least that’s true if you assume zero remains an, albeit rough, lower limit and central banks will, explicitly or not, cap yields close to zero to keep mountainous government debt loads affordable over time.
There are many “ifs” and “buts” in there, but that scenario is an increasingly consensus view and investment advisers at major banks such as JPMorgan, Societe Generale and many others are now saying alternatives to government bonds need be found.
After extensive number-crunching on past and prospective investment performances, JPMorgan’s long-term strategists Jan Loeys and Shiny Kundu told clients this week they should “significantly” reduce holdings of safe bonds given the low return horizon they see over the coming 5-10 years.
“In the zero-yield world which we think will be with us for years, bonds offer neither much return nor protection against equity falls,” they wrote, adding that the 10 percent per annum returns seen on a US 60/40 fund over the past 45 years will drop to as low as 3.5 percent over the coming decade.
US aggregate bond indices containing government, asset-backed and investment-grade corporate debt now yield a record low of 1.3 percent – a little over a fifth of its 44-year average – with just over 1 percent volatility. And this overall scenario is set to persist for many years.
Since 1985, they found that as bond yields fell, the volatility of annual returns also fell – most likely due to the gravitational pull of zero as yields get closer to it.
What to do? Simply increasing equity relative to safe bonds to make up the return just lifts the expected volatility and risk that many investment managers will baulk at.
And so the JPMorgan team reckon safe bonds should be replaced by what they called “hybrids” sitting somewhere between debt and equity.
Specifically they talk of equity-like bonds and bond-like equities such as high-yield corporate debt, collateralized loan obligations (CLOs), commercial mortgage-backed securities (CMBS), real estate investment trusts (REITs), convertible bonds, and preferred and utility stocks.
