Iggo's Insight: Can you rely on bonds?

Faut-il acheter des obligations ?

The nirvana of long-term investing is high returns and low volatility. In core markets, higher returns come from equities, driven by economic growth. However, these returns can be volatile. Adding bond exposure to equities dampens the volatility of returns, even with today’s low bond yields. The underlying relationship is quite stable – when economic growth turns down, equity returns get hit, there is an expectation of lower real interest rates which boosts returns from bonds. Fears of geopolitical unrest and a health pandemic have already hit equity returns in 2020, and on those days that equity prices fell, bond returns were positive. If the impact of 2019 Coronavirus worsens, growth optimism will be eroded and that could remove a support for the otherwise bullish view on equities. Having some duration exposure should cushion any losses that come from an equity meltdown.

Equities down, bonds up...the song remains the same 

There have been twenty-five trading days in the US so far this year and the S&P500 has registered a negative total return on nine of them. Fears of an escalated conflict between the US and Iran had a bit of an impact at the beginning of January and more recently, news on the coronavirus has brought some volatility to markets. However, net-net the market is up over 3% in total return terms in 2020.  On each of those nine days that stocks fell, total returns from the US Treasury bond market were positive. Indeed, the correlation between equity and bond price moves has been at a negative 0.72 so far this year. For the whole of 2019, based on daily total returns, the correlation was -0.51. There has been a similar relationship between the asset classes in other markets. Daily returns from the German government bond market have tended to be positive on those days that the Euro Stoxx equity index has registered a decline. The correlation between the two has been-0.63 so far, compared to -0.28 for the whole of 2019. With equities relatively expensive, at least in some markets, and earnings growth yet to be convincing (and Q1 will be impacted by the virus in some economies), it is important to reflect on the role that bonds can play in protecting investors’ downside.

The Hedge

The logic of holding low-credit risk government bonds in multi-asset portfolios to provide a hedge against negative equity returns still holds in my opinion. Moreover, the fact that interest rates and bond market yields have fallen to extremely low levels does not negate the value of the hedge. At the start of the year government bond yields were low but they have still managed to go even lower when equity markets have come under pressure. Over the last twenty-years, the negative correlation between bonds and equities has hardly changed, despite ever-lower yields. There is one caveat here – one needs to look at the relationship between returns over meaningful time periods. Over short-term horizons the correlation can be unstable, but under time periods that are more in line with investors taking a medium to long-term view, correlations between bond and equity returns are negative. Since the European Central Bank reduced its policy rate to below zero in March 2014, there has still been a negative correlation between European equities and German government bond returns. This is important for investors who are looking for diversified portfolios with a growth bias but with volatility and potential drawdowns that are not linked entirely to the equity market.

Longer duration 

In thinking about the role of bonds as a hedge, it is not the level of yields that is the most important but the sensitivity of bond valuations to changes in the level of yield. The duration – which measures this sensitivity – of bond indices has gone up significantly over the last two decades. Simply stated this means that it takes less of a decline in yields to boost the value of a bond portfolio by x% than it did ten or twenty years ago. To illustrate, the duration of the ICE Bank of America G7 Government Bond Index was 5.5 years in 2000. Today it is 8.5 years. If a bond allocation was matched against such an index, the value of the portfolio is now 16% more sensitive to a basis point change in yields than it was twenty years ago. It took a 90bps decline in yield to deliver a 5% capital gain in the index back in 2000. It takes only takes a 59 basis point decline in yields to get the same capital return today. 

Lower yields but...

The logic of holding low-credit risk government bonds in multi-asset portfolios to provide a hedge against negative equity returns still holds in my opinion. Moreover, the fact that interest rates and bond market yields have fallen to extremely low levels does not negate the value of the hedge. At the start of the year government bond yields were low but they have still managed to go even lower when equity markets have come under pressure. Over the last twenty-years, the negative correlation between bonds and equities has hardly changed, despite ever-lower yields. There is one caveat here – one needs to look at the relationship between returns over meaningful time periods. Over short-term horizons the correlation can be unstable, but under time periods that are more in line with investors taking a medium to long-term view, correlations between bond and equity returns are negative. Since the European Central Bank reduced its policy rate to below zero in March 2014, there has still been a negative correlation between European equities and German government bond returns. This is important for investors who are looking for diversified portfolios with a growth bias but with volatility and potential drawdowns that are not linked entirely to the equity market.

When necessary 

Having said all this, it has to be pointed out that bonds are not a perfect hedge. The correlation is not negative 100%. Also, in shorter time periods the correlation is not stable and can be, and has been, positive. Indeed, when we look at different periods of equity market returns, the correlation between equities and bonds tends to be most negative at either extreme of equity returns (the bottom 25% of returns and the top 25% of returns). During benign market conditions, the correlation tends to be closer to zero or positive – these conditions are usually characterised by stable interest rates and decent economic growth. When bonds perform badly it is usually when monetary policy is being tightened in response to strong growth and inflation, conditions which tend to be associated with positive equity returns. When bonds do well it is usually when rates are being cut or are expected to be cut in conditions of slowing growth, usually associated with negative equity returns. However, the point is when you do need the correlation to work, it does. 

Look at the balance 

While the hedge isn’t perfect and the correlation can be somewhat variable through the cycle, there is no doubt that combining bonds with equities results in better risk adjusted portfolio performance over time. Using monthly data from the US, Europe, UK and at the global level, we simulated risk-adjusted returns for portfolios that had a bond weighting between 0% and 100%. Increasing the bond weighting, using a representative all-maturity index in each market, reduced volatility a lot more than it reduced total return. For example, at the global level a 50:50 equity/bond portfolio over the last twenty years – assuming that one could fully replicate the index returns and not accounting for the cost of monthly re-balancing – would have delivered a simulated annualised volatility of 8% compared to 16.5% for the equity index alone. The annualised total compound return would have been 5.0% compared to 5.5% for a pure equity return.

Longer duration, more effective hedge

Substituting a longer duration bond index for the all-maturity version gives even stronger results. Using indices with a maturity of more than 10-years in each market resulted in portfolios that had a reduced in volatility and an increase in total returns as the bond weighting was increased, with the optimal weighting over the time period being between 50% and 75% in bonds. The longer the duration of the bond weighting, the more volatile those returns are (i.e. the volatility of the US Treasury 10-Year Plus index has historically been twice that of the all-maturities index). The combination of higher volatility (higher return) and negative correlation makes the putting long bonds and equities together very attractive. If one had been able to execute this in in reality over the last twenty years, a “S&P/Long US Treasury” strategy would have had very limited drawdowns and a monthly volatility of half of that of the of the S&P index itself. The chart below shows the simulated risk and return characteristics of different combinations of equities and bonds for the global market. The equity index is the MSCI World Total Return index and the three curves represent adding different types of bonds (1-3 year G7 government bonds, 10-year plus G7 government bonds and the all-maturity G7 government bond index, all expressed in US dollars. In the weightings, 0% bonds = 100% equities).

 

Source: Refinitiv Datastream, ICE Bank of America, AXA IM – February 7th 2020

 

Will it always be?

Using historical data and identifying relationships between asset class behaviours does not necessarily tell us what is going to happen going forward. Bond yields are low and have already moved lower this year. Many will believe that this will reduce the effectiveness of the bond hedge. There is no reason to suggest that this belief is correct. It hasn’t been historically once you allow for an appropriate holding period. If bond yields do stay low or even lower, then bond duration will remain higher or even increase which will support the effectiveness of the bond hedge in stressed equity markets. Bond returns might not be as strong as they have been over the last twenty years but there is no guarantee that this will be the case. It is entirely possible to get high single digit or even double digit returns from longer duration fixed income assets if we do see further declines in bond yie.ds. For example, the 15-year and over French government bond index has a duration of 20 years. A 50 basis point drop in yield would deliver 10% capital gains. 

Best of beta

I personally think there is value in investment strategies that mix equity allocation with bonds, giving investors exposure to the best of beta in markets that provide enough liquidity to allow exposures to be managed relatively cheaply over time. Diversification is crucial in the success of any long-term investment approach. The analysis and numbers referred to above are theoretical and based on historical data. As I said they don’t take into account trading costs, assume that index returns are always achievable and rely on effectively re-balancing the allocation on a monthly basis. Nevertheless, there are key messages. The first is that high quality government bond and equity market returns are negatively correlated over meaningful time periods. Combining the asset classes can improve risk-adjusted returns. Secondly, the decline in bond yields has not materially diminished the magnitude of the negative correlation – particularly when we are focussed on bond indices as the reference. The rise in duration has offset the decline in yields to leave bonds more sensitive to changes in market interest rates. Thirdly, the longer the duration of the bond exposure, the more effective the hedge is. A US Treasury index with a maturity of over 10-years has had a historical return volatility of around 10. The S&P’s volatility has been around 16. The correlation between the two has been -0.31. Putting long bonds in an equity portfolio would have had the effect of increasing return and lowering volatility.  

One for the ages

Having said all this, it has to be pointed out that bonds are not a perfect hedge. The correlation is not negative 100%. Also, in shorter time periods the correlation is not stable and can be, and has been, positive. Indeed, when we look at different periods of equity market returns, the correlation between equities and bonds tends to be most negative at either extreme of equity returns (the bottom 25% of returns and the top 25% of returns). During benign market conditions, the correlation tends to be closer to zero or positive – these conditions are usually characterised by stable interest rates and decent economic growth. When bonds perform badly it is usually when monetary policy is being tightened in response to strong growth and inflation, conditions which tend to be associated with positive equity returns. When bonds do well it is usually when rates are being cut or are expected to be cut in conditions of slowing growth, usually associated with negative equity returns. However, the point is when you do need the correlation to work, it does. 

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