Offsetting risk through diversification

The International Monetary Fund’s recent estimate showed an organisation coming to terms with the fact that medium-term growth will be slower than expected. You can see why, as the numbers are merciless.

Potential growth comes from more people and productivity, and the outlook for both has rarely been worse. The labour force seems set to grow at an ever-slower pace as population growth slackens and the proportion represented by the elderly rises rapidly.

There is less certainty on the productivity side. Theories abound on what drives it: investment, regulation, financial systems, technological transfer, debt levels, necessity, to name just a few. Each can credibly be said to explain part of the dramatic slowing we have witnessed since the Great Recession, and none promises salvation.

Slower growth and lower inflation are good for bond prices as the fixed payments look more attractive, and the opportunity cost of not being exposed to a growth asset is lower.

So it is not surprising that investors have piled in and pushed yields down. But their actions have been compounded by central bank buying and negative policy rates.

The result is that many government bond yield curves are negative at the front end and flat enough to provide barely any yield at longer maturities. Around 30 per cent of the bonds in the BofA Merrill Lynch Global Government Bond index now have negative yields, locking in a capital loss for investors who hold the asset to maturity.

With such little yield available in traditional government bonds and the risk of a sell-off ever present, investors may be considering other options for anchoring their portfolios. David Stubbs, JPMorgan Asset Management

This not only reduces their usefulness as a source of income, but leaves them stretched in valuation terms and prone to rapid sell-offs, as periodically witnessed in recent years.

The situation is even more extreme when considering real returns as the yields on many government bonds are below the current level of inflation in their countries and far beneath their central banks’ inflation targets.

If investors are holding government bonds for capital preservation and portfolio stability purposes, then most securities in the developed market bond universe are already failing to fulfil those roles.

With such little yield available in traditional government bonds and the risk of a sell-off ever present, investors may be considering other options for anchoring their portfolios.

Assuming a starting point of solely domestic sovereign fixed income forming a more stable part of a portfolio, investors have a wide range of options to consider for diversification, including:

Unconstrained fixed income: There are some countries in the developed world – and other categories of fixed income – with higher sovereign bond yields than in Europe. Allowing a fund manager a global unconstrained remit can assist in portfolio stability and yield generation.

Long/short debt or equity funds: These funds aim to produce relatively stable returns that exceed cash. Their return streams are often uncorrelated with core fixed income and provide stability during times of bond turbulence.

Hedge fund and synthetic fixed income replacements: A new breed of funds has been developed in recent years that aims to provide low-cost access to hedge funds themselves or to replicate their strategies. These vehicles target uncorrelated returns across market cycles.

This is certainly not the time to take outsized risks. To control the multiple risks faced by investors – some of them now coming from those very government bonds that were once the anchors of ‘risk-free’ portfolios – requires a more diversified approach.

Looking to the bonds of other developed governments, seeking stable performances from funds that balance owning securities with shorting others, holding a little more cash and taking advantage of the innovation in liquid alternative products can be part of the solution.

David Stubbs is global market strategist at JPMorgan Asset Management