Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 238

Does fixed income diversify portfolio risk?

The coordinated global fall in interest rates since the 2008 financial crisis has been one of the greatest tailwinds to asset prices in modern financial history. Interest rates underpin the valuation of most financial assets as their expected future cash flows are discounted relative to government bond yields. The effect of falling discount rates has been to increase their present capital values (i.e. their prices).

This dynamic has become progressively more extreme as the accumulated effect of extraordinary central bank intervention - abnormally low interest rates, combined with asset purchases - has pushed government bond yields to historically low (or even negative) levels and propelled investors to ever greater heights of risk-seeking behavior.

Is the party finally over?

This tailwind is subsiding. While the stronger global economic growth and declining central bank policy stimulus narrative is becoming more widespread, the missing chapter of the story has been inflation, which has been slow to emerge.

Not only is low inflation pervasive today, it has also become stubbornly entrenched into inflation expectations far into the future as markets assume the party continues along with very gradual policy normalisation.

However, given this policy normalisation is occurring after an unprecedented period of market-distorting stimulus, it is far from clear what the unintended consequences will be for financial markets. Even a little unexpected inflation can easily upset this delicate balance.

There are early indications that inflationary pressures are building. Notably, labour markets globally are tightening, manufacturing costs are rising and even in the land of deflation, the Bank of Japan recently noted that inflation expectations have stopped falling.

For years, central banks have prolonged stimulus without any real knowledge whether inflation transmission is working, thereby risking an overshoot. History shows that when inflation expectations shift, they shift quickly, which could force more aggressive policy normalisation than markets are expecting.

In this scenario, the party may be over.

What does this mean for investments?

Assets that shone brightly against the dim light of a low interest rate world would be reassessed under the harsh glare of higher interest rates. Against this backdrop, it’s natural to question whether government bond holdings can still play their traditional role as risk diversifiers.

Let’s begin with the traditional context, where a conventional ‘risk-off’ scenario like a recession occurs. Investors can probably expect their government bond holdings to help offset equity losses as capital flees to safety and bond prices rise as interest rates are cut.

Alternatively, if the current consensus view – improving growth, contained inflation and gradually rising rates – does play out, bonds provide stable income but still expose investors to risk of modest capital losses from rising interest rates (duration risk).

The current combination of very low yields and term premia (compensation for holding long maturity bonds over shorter bonds) means bond holders are being poorly compensated for bearing duration risk as a form of risk diversification. The issue is compounded for passive bond investments as benchmark index duration has extended (taking more risk), while average yields have declined (less return) creating an asymmetric risk of capital losses from rising interest rates.

Source: Ardea, Bloomberg

Even in the scenarios where bonds perform as intended, it is expensive to passively hold them at present for risk diversification.

But it could be worse

The underestimated scenario – nascent inflationary pressures become more established – would quickly shift focus to fear of inflation overshooting, forcing aggressive, unexpected and disruptive normalisation of monetary policy. Bonds then become the catalyst for a broader asset class sell-off, rather than acting as a defensive risk diversifier.

We got a small taste of what such unanticipated policy tightening can do to markets during the ‘taper tantrum’ in 2013. Ben Bernanke unexpectedly announced the possibility of reducing the US Federal Reserve’s bond buying programme, causing bond prices to drop sharply and triggering a sell-off in equities. The chart below shows how the Australian bond-equity correlation behaved before and after this event – becoming more positive, more often, and thus less reliable as a diversifying relationship.

ASX 200 vs. AU Govt. Bond Correlation

Source: Ardea, Bloomberg

In fact, this marked change is not unique to Australia or to recent history. Very long-term US data shows that bond-equity correlations are unstable, tending to be impacted by inflation and interest rate paradigm shifts.

5-year rolling bond yield - equity correlation (daily returns)

Source: Ardea, Shiller, R. Source data for Irrational Exuberance, 1871 to present.

Irrespective of whether we are in a paradigm shift in bond-equity correlations or not, the conclusion remains the same. The assumed negative correlation between bonds and equities is not as reliable as hoped for.

The implication for portfolio construction is clear. Investors should evaluate conventional assumption that passively owning government bonds is inherently defensive and risk diversifying.

More to fixed income than buy and hold

There’s more to fixed income than just buying and holding bonds. It is an asset class with a wide range of instruments, strategies and return sources that can be exploited to achieve genuine risk diversification. For example, the same factors that distorted bond market valuations have also created relative value pricing anomalies, underpriced volatility, skewed risk premia and offered cheap tail risk opportunities that can all be used for effective risk diversification in a truly defensive fixed income portfolio.

So yes, fixed income can still diversify portfolio risk but only if you choose the right strategy.

 

Gopi Karunakaran is a Portfolio Manager at Ardea Investment Management, a boutique fund manager in alliance with Fidante Partners. Fidante is a sponsor of Cuffelinks. The information in this article is general in nature and is not intended to constitute advice or a securities recommendation.

 

RELATED ARTICLES

Investors need to look beyond bonds for safety

Rising recession risk and what it means for your portfolio

How bonds may temper equity market disappointment

banner

Most viewed in recent weeks

The nuts and bolts of family trusts

There are well over 800,000 family trusts in Australia, controlling more than $3 trillion of assets. Here's a guide on whether a family trust may have a place in your individual investment strategy.

Welcome to Firstlinks Edition 581 with weekend update

A recent industry event made me realise that a 30 year old investing trend could still have serious legs. Could it eventually pose a threat to two of Australia's biggest companies?

  • 10 October 2024

Welcome to Firstlinks Edition 583 with weekend update

Investing guru Howard Marks says he had two epiphanies while visiting Australia recently: the two major asset classes aren’t what you think they are, and one key decision matters above all else when building portfolios.

  • 24 October 2024

Preserving wealth through generations is hard

How have so many wealthy families through history managed to squander their fortunes? This looks at the lessons from these families and offers several solutions to making and keeping money over the long-term.

A big win for bank customers against scammers

A recent ruling from The Australian Financial Complaints Authority may herald a new era for financial scams. For the first time, a bank is being forced to reimburse a customer for the amount they were scammed.

The quirks of retirement planning with an age gap

A big age gap can make it harder to find a solution that works for both partners – financially and otherwise. Having a frank conversation about the future, and having it as early as possible, is essential.

Latest Updates

Investment strategies

Warren Buffett is preparing for a bear market. Should you?

Berkshire Hathaway’s third quarter earnings update reveals Buffett is selling stocks and building record cash reserves. Here’s a look at his track record in calling market tops and whether you should follow his lead and dial down risk.

Economy

US election implications for investors and Australia

The return of Donald Trump to the US presidency brings the prospect of more US tax cuts and deregulation, but also more tariff hikes, trade wars and policy uncertainty. Here's what it means for markets going forward.

Retirement

The rising tension between housing debt and retirement balances

Australians are taking more mortgage debt into their 60s than ever before. Retirement planning assumptions haven’t adapted and could result in future income projections that ultimately disappoint retirees.

Investment strategies

Why megatrends can deliver big upside (and downside)

The magnitude and duration of society's most important trends are often underestimated. While these trends are usually touted as a tailwind, one in particular could have dark consequences for many assets.

Property

Fixing the construction industry house of cards

Australia needs to build new homes like never before but construction firms keep going belly up. Unless regulators act now, consumers will continue to carry the can.

Investment strategies

How investor portfolios have become riskier versus history

Risk in portfolios has dramatically increased as time horizons have shortened and investors have piled into equities. It's resulted in a growing disconnect between what investors need and what the financial industry is delivering.

Shares

The abacus, big data and a brief history of indexing

Equity indices have evolved over time, led by step-changes in our ability to manipulate data. Despite the rise of passive investing, they weren't initially meant to be investment tools.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.