Fixed income markets have enjoyed one of the greatest 30- to 40-year bull markets in history.
With 10-year government bond yields falling from highs of over 15 per cent in the early 1980s to lows of 2 per cent today, the asset class has delivered unprecedented outcomes on a risk-adjusted basis for cautiously-minded investors.
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).
At this juncture, it is therefore healthy to remind ourselves of the two key roles lower-risk bonds play in a portfolio: 1) as a source of return, and 2) to diversify equity risk. Investors should think about these two key roles carefully, including the impact of lower yields and the various scenarios that could present themselves.
It is also useful to pause and contemplate what a government 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. However, investors need to go beyond generalisations and average correlations – instead focusing on the possibility for different types of equity shocks and how these might affect bond yields.
While the theory is that when stocks go up, bonds go down - and vice versa - it is worth observing broader history because we know this can be grossly misleading over extended timeframes.
The above analysis can help us to determine how fixed income can play a role in a portfolio. What we are really trying to understand is the holistic profile of the investment universe and how bond markets can be best used, given the state of the broader opportunity set.
Rising interest rates must also be respected as a potential scenario, as history tells us that it can have a meaningfully depressive impact on both equity and fixed income returns. It is therefore dangerous to extrapolate the last 15 years of negative correlations and simply expect it to provide diversification benefits to a portfolio.
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 have much appeal by way of attack (poor long-term return prospects), but 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).