Bonds: still the best safe haven?

Bonds were universally regarded as the ultimate defensive asset for a very long time, but a period of low yields has called into question whether fixed income is still the best way to achieve an optimal multi-asset portfolio. 

So what are defensive assets, and which ones should clients include in their multi-asset portfolios? 

Defensive assets 

Jean-Marie Debeaumarché, multi-asset portfolio manager at CPR Asset Management, says defensive assets are an important part of a multi-asset portfolio construction process due to their low correlation properties. 

He adds: “Their lower beta and/or even uncorrelated features with traditional risk assets are useful to improve the risk-reward profile of multi-asset portfolios.”

Jochem Tielkemeijer, investment consultant within the dynamic solutions team at Natixis Investment Managers, says: “There are many risks to consider for an investment portfolio, but in terms of volatility, defensive assets can reduce risk in two ways or a combination thereof: first, be less volatile than the portfolio, or second, have lower correlation with other asset classes in the portfolio.”

Key Points

• Questions arise over whether fixed income is still the best defensive asset
• The yield curve has recently inverted
• Gold is another option as a safe haven asset

But Jim Smigiel, chief investment officer of non-traditional strategies at SEI Investments, points out that the definition of a defensive asset varies in line with market conditions. 

There is no Swiss Army knife-type defensive asset Jim Smigiel, SEI Investments

“Investors tend to associate bonds with the defensive label given the actions of global central banks since the financial crisis,” he says.

“In reality, there is no Swiss Army knife-type defensive asset. Therefore, investors should focus on ‘diversifying’ assets, which allow for higher levels of risk-adjusted return.”

But the industry is divided as to the importance bonds play in multi-asset portfolios since the asset class has come under increased scrutiny in recent months due to low yields. 

Bond yields 

In August, the yield curve inverted, sending a signal that the bond market may be predicting a recession. 

The yield curve is a visual representation of how much it costs to borrow money for different periods of time. An inverted yield curve has preceded every single recession since the second world war, but not every inversion has been followed by a recession.

It should typically cost more for a country to borrow money over a longer period of time; this is why longer-term bonds usually yield more than shorter-term bonds to compensate investors for taking on greater risk. But this relationship has flipped in recent months as three-month US treasury bonds have yielded more than the 10-year US bond. 

The main reason why bonds played a key role in multi-asset portfolios is due to their low correlation to equities. 

Mr Debeaumarché says: “[The] lower bonds yields go – deep negative territory like German or Swiss debt – the lower their diversification/defensive benefit going forward as both their carry and price gain potential become less appealing.”

Mr Tielkemeijer says since equities are often the prominent risk driver in a portfolio, assets that do not have correlation with shares are very useful for diversification purposes. 

“Historically, these assets have been fixed income; however, in this extraordinary rate environment some categories within fixed income may no longer provide the risk-and-return profile investors are looking for in defensive assets.”

But he points out that bonds with a lower duration can still be defensive in nature amid an environment of low and even negative yields. 

Nick Watson, portfolio manager in the multi-asset team for Janus Henderson, says: “Investors can choose to allocate more to short-dated or lower-duration bonds, which arguably offer compelling risk-adjusted returns relative to longer-dated bonds given the current shape of yield curves.”

The risks are certainly rising for higher-duration debt.

Mr Watson explains: “With much of monetary policy exhausted, the argument for fiscal expansion from more populist-leaning governments is building.”

He adds: “More government borrowing, spending and infrastructure investment would suggest higher inflation, which is a different environment to that of the past decade and would pose challenges for high-duration defensive assets.”

While bonds are still deemed partially attractive, experts point out several other defensive assets that can provide similar diversification benefits. 

Alternatives to bonds 

Gold remains a popular asset class to include in multi-asset portfolios as a safe haven to mitigate geopolitical risk. 

Mr Smigiel says: “Exposures like gold offer opportunities to protect against geopolitical events and general financial calamity. It’s important for investors to maintain diversified exposures to various risk premiums at a total risk level with which they’re comfortable.”  

Damian Barry, head of multi-asset multi-management for Mediolanum International Funds, says gold has proven to be a valuable investment when equity markets are in free fall as happened in 2008. 

But he warns that gold does not yield any regular income. 

“The caveat is that gold doesn’t produce any income, so it can drop relatively quickly, as it did in the second quarter of 2013 when it lost almost 25 per cent, at the time of the ‘taper tantrum’,” adds Mr Barry. 

The taper tantrum was a period of panic that caused a spike in US bond yields after investors found out that the Federal Reserve was intending to cease its quantitative easing programme. 

Mr Watson says: “Asset allocators can express a defensive stance within their equities by allocating to high-quality defensive companies. Alternatives, such as infrastructure assets or gold, also have defensive characteristics with complementary return streams to equities and bonds.”

Some in the industry have suggested that cash and exposure to foreign exchange can also be a defensive strategy. 

Mr Watson says: “Cash is a tactical tool for dampening volatility and managing drawdowns. With bonds and other defensive assets looking expensive versus history, cash may prove to be better protector of capital than conventional bonds.”

Mr Smigiel thinks commodities and other inflation-sensitive assets are good alternatives to the current state of bonds. 

“Given the recent performance of these asset classes prior to 2019 and the general outlook for inflation, we tend to believe this is an under-owned part of the capital markets that can be extremely diversifying to an investor’s portfolio,” he adds. 

Saloni Sardana features writer at FTAdviser and Financial Adviser