Bonds may be causing an imbalance in portfolios
It’s hard for seasoned investors not to give in to nostalgia for the days when government bonds could be counted on for both inflation-beating income and portfolio protection in times of market stress.
In our current times, the good old days of the 60–40 portfolio — mostly equities with a good slug of safe, income-producing bonds that had cash-like liquidity — seem almost mythological.
Today, so many bond yields are negative that investors the world over are effectively paying governments for the privilege of lending them money. We think it’s likely that gilts would continue to appreciate in value in the event of further sharp falls in equity markets (they would be negatively correlated). However, we would expect the fall in yields (and hence increase in price) would be of a significantly smaller scale given the lower absolute level of yields at the moment. So lower yields and less protection in market sell-offs — not the most attractive of propositions.
So, what’s a cautious investor to do, short of sticking their cash under the mattress?
Rather than focus just on relative or potential returns — whether income, capital gains or both — we believe portfolios should also be built with risk protection in mind. To do that, we divide assets into three building blocks, which play different roles — liquidity (mostly safe-haven government bonds and cash), equity-type (such as shares, corporate bonds and emerging market debt) and diversifiers. Using this ‘LED’ framework helps us better understand the potential for losses at the overall portfolio level.
What comes down must go up
As noted above, we can envisage a scenario where gilt yields go even lower. But the laws of nature in the bond universe look unfavourable in the current environment. The lower interest rates go, the greater the risk for investors that they will go up in the future, which equals falling bond prices. Given that interest rates have been moving lower for decades, most investors may not have experienced this phenomenon, and for the rest it’s a distant memory. It’s hard to see a catalyst for rates to go up in the foreseeable future, but we shouldn’t get too complacent about yields staying low forever.
The other difficulty for bonds today is that, even if rates do keep going down, there is a lot less room for them to do so given how low they already are (and therefore how high prices are) relative to history. What could drive bond prices higher into the stratosphere? We think it would take either a greater risk of deflation (falling consumer prices) or the Bank of England (BoE) deciding to take official interest rates into negative territory, or both.
We’ve questioned BoE Governor Andrew Bailey and his colleagues about negative interest-rate policy (NIRP) at various roundtables and conferences, read their recent speeches on the subject and listened to the feedback from the large commercial banks that are in close contact with the central bank. It’s clear to us that the BoE has not yet determined if negative rates are operationally feasible, whether they are likely to be effective in the context of the British financial system, or if they would be appropriate given the state of the UK economy (see our Investment Update on dealing with rising UK debt). In short, we expect negative rates would only come as a last resort, and the successful COVID vaccine trials and a Brexit deal have clearly diminished the chances of NIRP coming to these shores.
What about the chances of interest rates rising significantly from here, and returning to some semblance of the old norms? We think it’s low over the next year or two at least. As the economic recovery matures and appetite from households and business to take on more debt grows, it’s possible that interest rates could rise to avoid an overheating. In such a scenario, government borrowing costs may face some upward pressure. But we think inflation in the UK and other major developed economies is likely to remain stubbornly low for the foreseeable future, and central banks are more likely to be concerned about keeping prices supported than about keeping inflation from overheating (see our Investment Update on inflation).
A shakier footing
Although gilt yields were already very low when COVID-19 struck in the first quarter, that didn’t stop them from going lower (and prices going up further) as riskier assets like equities plummeted. The capital return on 10-year gilts was about 5% in 2020, with a total return of around 6% when including coupon payments.
As we noted earlier, it’s probable that in the event of another growth scare gilt yields could fall further yet, again providing offsetting gains. After all, some £13 trillion of global debt was already trading at negative yields at the end of last year. However, any further price increases during such times are likely to be less with the lower absolute level of yields. Also, the historically negative correlation between equity and bond returns has become more sporadic in the current era of ultra-low rates. This creates a need for alternative sources of portfolio diversification.
A traditional alternative to so-called conventional gilts is index-linked gilts, whose returns are linked to moves in inflation. ‘Linkers’ had some attraction in the short term as a hedge against a hard Brexit, which could’ve led to a fall in the pound and rising import prices. But longer-term, and with that risk now off the table, we think they are pricing in too much inflation risk and are therefore less attractive than the conventional variety.
They look particularly expensive when we consider the recent announcement on reform of the Retail Price Index (RPI), which we have been wary of for a while. In 2030, we can expect RPI to be aligned with the Consumer Price Index including housing costs (CPIH), which historically has been significantly lower than RPI. Therefore, returns for index-linked gilts will be lowered from that point.
In this new normal of ultra-low rates, high-quality corporate bonds are another ‘unconventional’ approach for keeping your money safe and accessible (or ‘liquid’), while getting at least a bit more yield than what’s on offer from gilts (conventional or otherwise). Though not traditionally looked to for liquidity, we believe high-quality corporate bonds can continue to provide these benefits during a contracting business cycle.
Thinking even longer-term, low interest rates are a function of desired savings and desired investment. Over the past four decades, the desire to save has increased and the desire to invest has decreased due to a range of structural factors including demographics, rising inequality, the global savings glut, lower public investment, falling productivity, and financial engineering.
These are highly unlikely to screech into reverse. But given the paltry yields on offer, gilts may come under pressure if the risks to the COVID recovery recede further over the coming months. At the same time, the additional yield on offer from high quality corporate bonds may look even more attractive.
In addition to that bit of extra yield, these low-risk corporate bonds can also cover some of the need for liquidity within a typical balanced, or cautious, portfolio. But they may not provide sufficient diversification, and hence the need for other assets in what we call the diversifiers bucket – the ‘D’ in our LED framework. We believe using a combination of these ‘LED’ assets allows us to construct a portfolio which will provide more attractive risk/return metrics than the classic 60—40 portfolio with government bond yields so depressed.
If you’d like to find out more on the different kinds of diversifying strategies and their importance you can read more in “Diversifiers provide an antidote”, an article our July edition of Investment Insights, or speak to your investment manager.