Losing my religion: What is the point in bonds?
Reviewing their usefulness at a time of intense volatility
Bond yields plunged to historic lows in August, which left 40% of the total bond market capitalisation trading at negative yields.
What extraordinary times are these? 10-year US Treasury yields peaked 38 years ago at 15.84% and now offer 1.61%.
The core inflation rate was 9.5% in 1981, whereas the current core US inflation rate is 2.4%.
For investors who have traditionally relied on bonds to provide lower risk defensive diversification, this is a serious concern.
At current yields, developed market government bond returns have become less certain, the risk of a negative outcome over the next five to seven years has become higher and their defensive qualities are much more muted than in the past.
There is little joy to be offered in assets that offer 'returnless risk'.
So, what is the point in bonds? Certainly, a move into outright recession might yet result in new lows being made, but such an outcome is only likely to be temporary.
Until bonds re-price and reasonable risk premia are restored, we will be compelled to treat them as tactical as opposed to strategic assets and seek defence elsewhere via options, currencies and short growth positions.
Generally, we require a defensive exposure to generate an appropriate return, albeit over different horizons to the growth assets within the portfolios to further balance risk.
Benchmark definitions of bond beta have been problematic at the best of times and we espouse an unconstrained approach, where each bond holding is assessed and selected individually.
There can be opportunities even within asset classes that are suffering from broad risk premia compression. In 2018, long-dated US Treasuries were a case in point.
Last November, 30-year yields hit 3.45% (at which point the market was expecting the US Federal Reserve to raise interest rates at least three times over the course of 2019), as episodic fears about official rate increases caused a panic.
However, in the recent past they briefly touched a low of 1.95%, providing materially better returns than equity markets over that period.
At these yield levels, curve 'steepeners' may provide a better source of diversification with respect to any further slowdown in US growth than structural allocations to bonds.
Being able to control risk more precisely within bonds as an asset class by adopting a highly selective approach to bond investing and managing currency risk separately may have been a luxury in the past, but it will be a necessity in the future.
Convention dictates that diversified portfolios should have structural allocations to 'vanilla bonds' to add defence, moderate volatility or to hedge liabilities.
I realise that a former fixed income manager making the case against structural allocations to bonds must seem heretical, but to paraphrase the song from REM, I have lost my religion.
Philip Saunders is co-head of multi-asset growth at Investec Asset Management
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