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What to do when bonds do not diversify

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

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

More recently, though, low nominal yields, negative real yields and a potential repricing have made bonds a much less reliable portfolio diversifier.

However, in spite of all the negative sentiment towards bonds, there are certain scenarios where we believe that 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.

Past performance and the reliability of diversification are no guide to the future, however, 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 – something especially likely if we enter an unexpected period of much higher inflation.

Interest rates remain considerably below longer-term history and have simply unwound the downward overshoot that occurred during the early phase of the pandemic.

However, 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, but 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, that is, investments that can act in harmony to either protect portfolios when equities are falling, or to provide the return that bonds have achieved in the past.

Diversification within fixed income

Investors in the fixed income space can diversify their portfolio by incorporating different strategies.

Countries with steeper yield curves can still offer significant diversification when risk assets fall due to the fact that they have more room to compress, for example.

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 assets can play a critical role in portfolios and, not least, offer protection against high inflation, which is an environment in which government bonds are unlikely to be able to diversify.

However, caution needs to be exercised around those real assets that have already been excessively bid up in the search for yields by investors – of which there are quite a number.

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.