Arguing for the diversification benefits of government bonds does not mean they will be great returning assets.
Allocations should probably be lower than has been the case historically; we are now paid much less to hold this insurance asset than in previous years, and indeed we may face a negative cost under some scenarios.
If US bond yields increased to 5 per cent this certainly would no be pleasant for bond holders; however, such a scenario would also be bad for large parts of the equity market. Low-risk free rates are not just a return headwind for government bonds, they lower return expectations generally, so it is important to look for diversifying assets that may also offer higher expected returns to sit alongside core equity exposures.
Staying with bonds, with low yields in many core bond markets, non-traditional and specialist credit can enhance portfolio characteristics. Here, sensitivity to interest rate movements tends to be lower, and yields can be higher due to the specialist nature of the bonds, which may be associated with a specific economic sector or underlying asset, or the way the cash flows are structured. Such areas can be risky though, so the risk management of such a strategy and how the underlying exposures interact with other areas of the portfolio are important considerations.
China in your portfolios
China government bonds can play an interesting role in a diversified portfolio. Yields are higher than developed market government bonds, and reflecting China’s somewhat disconnected stance from developed economy cycles, China government bonds have historically offered low correlations to traditional assets, while volatility has been much lower than other emerging bond markets.
Currency needs to be considered carefully, although a modest allocation to Renminbi may offer another source of diversification, and potentially currency appreciation benefits over the medium to long term if China succeeds in its objective of increasing the use of the Renminbi internationally.
Although correlations can be period dependent, at a time when valuations are high in many asset markets, out-of-favour assets can offer a natural correlation benefit, although allocating to such assets may feel uncomfortable initially.
China is at a different point in its cycle, both in terms of monetary policy and its approach to regulating the economy. Hence, although currently out of favour, assets like China-exposed equities and Asia credit may offer longer-term diversification benefits, and potentially superior expected returns, when such assets come back into favour.
Currency, cash and other exposures
