investment viewpoints

Are the diversification benefits of government bonds broken?

Are the diversification benefits of government bonds broken?
Alain Forclaz - Deputy CIO, Multi Asset

Alain Forclaz

Deputy CIO, Multi Asset
Aurèle Storno - Chief Investment Officer, Multi Asset

Aurèle Storno

Chief Investment Officer, Multi Asset

One of the classic principles of portfolio management has been the diversifying qualities of government bonds. From traditional 60/40 or ‘balanced’ portfolios to multi-asset funds, government bonds have long represented the long-term stabilising influence to offset the often more volatile profile of equities. And this has worked well historically, largely because equities and bonds have generally been negatively correlated, particularly during periods of stress for risky assets.

Yet one of the measures to help curb the economic impact of COVID-19 has been for central banks to cut interest rates once more. While this has produced some positive near-term performance, with bond yields moving lower, and therefore generating a capital return, yields are now at unprecedented low levels raising the question of whether government bonds can continue to provide portfolio ballast going forward.


Why invest in government bonds?

This scenario has resulted in fierce debate surrounding the use of bonds in multi-asset portfolios. Some managers have heralded the end of government bonds, switching out of the asset class, sometimes completely, in favour of other perceived safe havens, including inflation-linked bonds and gold. Rather than taking such a drastic step – duration, after all, has been the only positive performance contributor among the traditional risk premia within our portfolios so far this year – we have instead focused on examining the reasons we invest in government bonds in the first place. This process of re-examination helps us ensure our investment process can adapt to changing market conditions, as well as enlarging our set of safe haven assets.

While we acknowledge that growth and inflation are the two key components of economic cycles, and drive the performance of traditional assets, our asset allocation process does not excessively favour any particular macro environment or scenario. Instead, we seek to balance risk systematically across a long-term growth/inflation economic cycle. Historically, such an approach has been able to deliver better risk-adjusted returns than capital-based portfolios, in our view. Additionally, our analysis of a variety of market configurations also supports this approach, these include a structurally low-rate environment, such as Japan since the 1990s, or periods of positive (or negative) bond-equity correlations.  

We seek to balance risk systematically across a long-term growth/inflation economic cycle

Our investment process has diversification at its core. We analyse all sources of return from a risk, rather than a capital, perspective. This means risk is integrated into all of our allocation and rebalancing principles. For example, if growth and inflation expectations were to become much more positive and uncertain (such as in the late 1970s), we would expect interest rates to rise together with higher volatility (reflecting price uncertainty), in which case our portfolios would mechanically reduce fixed income exposure, potentially below the typical 60/40 split of a traditional portfolio.

Furthermore, we believe that assessing the risk from any risk premia should be based on the risk of loss, rather than just focusing on volatility. This approach should be applied to forward-looking risk indicators as well as backward-looking, statistical ones. For example, we may use a valuation risk indicator such as a risk premium carry, which reflects the prospective return distribution: a higher valuation lowers the potential carry and increases the risk of loss.


Tactical deviations

We then seek to diversify our sources of return by integrating tactical deviations to our structural allocation. This could mean identifying trend signals and using this data to amend our portfolio positioning – bearish price action would trigger a reduction in portfolio positioning which could be longer-term if the moves are sustained. To illustrate the flexibility of our approach, in 2016 our exposure to government bonds switched from 75% in July (an all-time low for government yields at that time) to less than 35% in the aftermath of the US elections later that year.

The use of additional safe haven assets, not just government bonds, are also a critical part of our approach meaning we apply our diversification principles here too. Like many portfolio managers we use inflation-linked bonds and gold, but we also try to look beyond these typical safe assets in search of others. Our expanded tail hedge protection includes investments that aim to capitalise on a rise in volatility and these have proven to be very helpful this year. Cash is also an often-forgotten shock absorber and we use this simple mechanism actively – our portfolios had a 65% cash weighting at times this year, but have since been moved back to a fully invested position.



Finally, we believe a successful strategy is not just about being diversified across asset classes, but also being diversified within each asset class. This means looking beyond traditional sovereign bond markets, or indeed our home markets, a common tendency among investors. An example is North-East Asian bonds, which benefit from comparatively attractive rates and whose improved liquidity warrant inclusion in our portfolios.

In summary, we believe that concerns around low rates being fatal to risk-based portfolios are misplaced. Yes, it is a challenge for all multi-asset managers, but we believe a risk-based investment approach can help achieve better long-term, risk-adjusted returns. To us, this means staying true to our process and systematically managing a fully diversified portfolio that covers all asset types, including government bonds.

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