Will bonds bail you out next time?

The traditional wisdom is that investors typically benefit from a negative correlation between equities and bonds, with falling stock markets being associated with buoyant fixed interest markets as bond yields decline (and vice versa), thereby smoothing combined returns.

Wednesday, July 19th 2017, 6:00AM

While this is often the case in practice, the long-term experience tells us that the nature of the relationship is intricate and fluctuates over different time periods. As discussed in this article by David Scobie, head of consulting at Mercer, investors should consider how portfolios might be constructed to withstand an environment where the diversifying power of bonds may not "ride to the rescue".

“Understanding and anticipating the power of correlation - and thus the limitations of diversification - is a principal aspect of risk control and portfolio management.” – Howard Marks, Oaktree Capital

Amid highly accommodative global monetary policy, most of the past decade has proven to be a happy time for commonly-used "balanced" strategies dominated by equity and bond exposures. However, with equity markets reaching new highs and bond yields remaining extremely low by historical standards, such portfolios may face material headwinds over the medium-term.

These headwinds include modest forward-looking return expectations (given starting valuations), and the potential for a change in the behaviour of equity and fixed interest assets under certain economic scenarios.

A potential catalyst for such a change could be a shift toward a more inflationary environment in which tighter monetary policy and rising bond yields undermine the returns of traditional assets. Although higher levels of inflation are far from inevitable, the shift in policy discussions toward fiscal stimulus (evident in the US, Japan and, to a lesser extent, in the UK, Europe and NZ) at a time of synchronised global growth raises the prospect of inflationary pressures emerging.

One does not need to have a bearish outlook to see merit in contemplating two important points:

 What impact would a simultaneous sell-off in equities and bonds have on an investor’s financial position?

 What actions can investors take to improve the robustness of portfolios in an environment that poses significant challenges to both equities and bonds?

Know thyself

Before considering what portfolio changes might be appropriate, investors need to have a clear idea of the economic/market outcomes they are least able to tolerate. For example, investors who are sensitive to mark-to- market volatility or who are cashflow-negative may be most concerned about large market moves and a dramatic reduction in liquidity over a short space of time.

Conversely, long-horizon investors may be most concerned about the erosion of their purchasing power due to an extended period of higher-than- expected inflation.

The following questions will help investors narrow down the range of scenarios that are likely to be of most relevance when reviewing investment strategy:

 What time horizon matters most? Will the time horizon shorten during a period of market distress?

 What are the characteristics of the key financial commitments? Is there flexibility to adjust outgoing cashflows in difficult times?

 What other income support might be available, if required, in an unfavourable market environment? Under what conditions is that support most likely to be compromised?

Identifying the pictures of most concern and then testing the portfolio’s likely response under plausible future scenarios are critical steps in the risk management discussion. Investors can then assess, ahead of time, what portfolio adjustments might be warranted.

Seek robustness

Building on this discussion, investors can consider potential actions at three levels:

 Explicit hedges: Defensive exposures can be implemented to provide explicit protection against one or more economic/market outcomes. This category would include government bonds (nominal and inflation-linked), synthetic hedges (such as option strategies and swaps) and tail-risk hedging strategies (hedge funds or customised methods designed to provide a large positive payoff in stressed market conditions). Notwithstanding the comments outlined at the start of this article, nominal government bonds will still have a role to play in defending against weakening economic conditions and deflationary environments (especially for investors sensitive to those outcomes). Inflation-linked bonds will offer some exposure to rising inflation alongside their interest rate exposure, and synthetic hedges can be tailored to meet individual needs.

 Defensive tilts: Recognising the return drag typically associated with explicit hedges, investors can also consider “tilts” in asset allocation that might improve robustness in scenarios to which the investor is sensitive and potentially exposed.

This could include allocations away from equity and/or nominal bonds in favour of defensive hedge funds, absolute return fixed interest, or real assets with contractual income streams such as infrastructure. Low-volatility equity and sub-investment-grade credit might be more defensive than traditional equity exposures, but both are likely to be highly correlated with equities in a crisis.

 Additional flexibility: High-quality cash may have a role to play in reducing the risk of having to crystallise losses to meet cash outgo or collateral calls in stressed conditions. It also acts as "dry powder", offering the ability to redeploy assets at more attractive levels. The latter activity is best deployed by investors with a strong governance process and the capacity to frequently reassess their position.

A decision as to whether or not running a potentially more complex or higher cost portfolio is warranted can be built into the assessment process – such approaches will not be suited to all investors.

Balanced by nature

In summary, it is clearly not possible to protect portfolios against all potential environments.

However, investors can identify those scenarios that are most likely to impede the achievement of their goals and incorporate some portfolio protection against those outcomes.

In essence, investors should aim to safeguard tolerable portfolio performance, particularly where bonds may have limited ability to underpin overall returns. Broader risk management strategies can play a role in this process and help ensure "balanced" portfolios meet this description not just be name but also by nature.

This article from Mercer does not contain investment advice relating to your particular situation. No investment decision should be made based on this information without first obtaining appropriate professional advice and considering your circumstances.

Tags: bonds equities investment Markets Mercer risk yield