Strategic Bonds  

What to do when bonds do not diversify

What to do when bonds do not diversify
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Protecting portfolios from falls in equity markets is one of the most important and timeless issues for investors.

Traditionally, there have been several ways people approach this, with the use of government bonds being the most popular. This decision has historically been supported by attractive yields, simplicity, familiarity and an unconventional monetary policy, including a decade of quantitative easing.

More recently, however, low nominal yields, negative real yields and a potential re-pricing have made bonds a much less reliable portfolio diversifier. But, despite all the negative sentiment towards bonds, there are certain scenarios where we believe they can still offer effective diversification, namely a deflationary and/or negative interest rate environment.

By and large, a diversified portfolio of bonds remains the most favoured choice in such scenarios. Yet, past performance and the reliability of diversification are no guide to the future, and all that can be reasonably certain is that returns generated from bonds in the past few decades cannot be extrapolated into the next.

Worse still, there is a real risk — and plenty of historical precedents — of bonds exacerbating equity losses. This is especially likely if we enter an unexpected period of much higher inflation.

Interest rates remain considerably low and have simply unwound the downward overshoot that occurred during the early phase of the pandemic. But, with yields still so low and facing the prospect of continued repricing, it is more of a challenge to find the right balance between risk and reward.

This does not necessarily mean that bonds are to be avoided, only that it is sensible to explore the wide range of other options for effective diversification and portfolio protection.

We view alternatives to bonds through the twin lenses of risk mitigation and return enhancement: investments that can act in harmony to either protect portfolios when equities are falling, or to provide the return bonds have achieved in the past.

Diversification within fixed income

Investors in the fixed income space can diversify their portfolio by incorporating different strategies. For example, countries with steeper yield curves can still offer significant diversification when risk assets fall, as they have more room to compress. 

Alternative sources of real returns

Investors can look to multiple non-traditional sources of real return and diversification, such as infrastructure, listed real estate, commodities and inflation-protected bonds, to name just a few. Such assetscan play a critical role in portfolios and, not least, offer protection against high inflation — an environment in which government bonds are unlikely to be able to diversify.

However, caution needs to be exercised around the many real assets that have already been excessively bid up in the search for yields by investors. 

Defensive currencies

Some currencies like the Japanese yen and Swiss franc have historically acted as buffers during risk-off episodes, owing to their persistently negative-to-low interest rate environment. Carry strategies — where investors borrow currencies in low-rate jurisdictions to invest in currencies with a higher rate — tend to be unwound during risk-off episodes.