Fixed Income  

Quest for returns intensifies with bonds not delivering what’s ‘written on the tin’

Rory Maguire

Rory Maguire

Portfolio constructors have a real challenge in how to build a low-risk strategy that delivers a modest cash-plus return without risking capital.

Historically, this was quite easy. Even a bottom-quartile strategic bond fund delivered cash plus 3 per cent over the past five years. But with bond yields so low, how can clients with a limited appetite for equity risk achieve this?

We cannot rely on bonds to provide what was originally written on the tin – a low-risk strategy with modest upside and a steady income. In a world where yields are 3-4 per cent, income drives returns and softens capital downside. When nudging 1 per cent though, it is capital that drives returns and this means losses become more likely.

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There is a specific portfolio construction conundrum. Clients have come to expect cash plus 3 per cent, with a capital loss potential of less than half of equities and a volatility of around a third.

So how would we build such a portfolio when bonds appear more risky? We think that equities need to do the return heavy lifting, but the allocation should be low enough to ensure capital risk is not too extreme. Let’s call it a 30 per cent allocation, to deliver the first 1.5 percentage points above cash. Here we would favour global over regional and value over quality.

But what happens with the remaining 70 per cent that historically could have been absorbed by bonds? We see a few ways that providers look at this. First, the ‘back bonds anyway argument’ is an approach often supported by two rationales: they diversify equity returns and we may be in a low-rate world for a long time. However, we question the former logic: long duration high-quality bonds offer the best downside protection for equities historically, but duration seems overdone. And for bonds to absorb downside, yields need to fall a lot further, which seems unlikely. 

Therefore, if anything we favour small allocations to bonds and probably within cash-plus proxies, such as shorter-duration credit.

Second, investors could venture into less traditional areas, such as infrastructure, listed real estate or emerging market debt. However, like other income-yielding asset classes, we are wary of valuations and whether we are compounding the equity risk. So again, modest allocations.

Third, use absolute return funds. We like these because of the absence of viable alternatives, but also because we think taking market risk may not be sensible. The ideal absolute return fund should show ability to make money when markets are going down. 

We recognise their outcomes can be quite binary and so prefer a blend of many funds. While we use them primarily for capital protection, we would expect them to add 1-2 percentage points to the return goal.

Bonds and bond proxies carry increasing amounts of capital risk, while equities look pricey too. The value style appears to have some unlocked upside, which we find appealing.