Bond yields plunged to historic lows in August, which left 40% of the ICE BoAML Global Government Bond Index total bond market capitalisation trading at negative nominal and even more negative real yields. Austrian century bonds were the star of the show generating a year-to-date return of an incredible 65% to end September. US Treasury bond yields remained in positive territory, but the narrative at the time – extrapolative as ever – suggested that it was only a matter of time before they were at or below zero. What extraordinary times are these that the market environment could be so abnormal after a growth cycle that has lasted more than 10 years? 10-year US Treasury bond yields peaked 38 years ago at 15.84% and now offer 1.61%. Then the core inflation rate was running at 9.5% in 1981, whereas the current core US inflation rate is 2.4%.
Chronically low bond yields represent a challenge for low risk investors and savers who have traditionally relied on bonds to provide lower risk returns and defensive diversification in periods when growth assets have been weak. Not only have returns disappeared to vanishing point, risk levels have also increased because effective ‘neutral’ duration increases as bond yields fall. At current yield levels, 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 much more muted than in the past. There is little joy to be offered in assets that offer ‘returnless risk’.
So, what is now the point of bonds? As a structurally long beta position, there would seem to be little justification. Certainly, a move into outright recession might yet result in new lows being made but such an outcome is unlikely to be more than a temporary outcome. Until and unless 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 defensive exposure elsewhere via options, currencies and short growth positions. Our Growth – Defensive – Uncorrelated (‘GDU’) approach to structural diversification across our Multi-Asset strategies accommodates this.
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 which 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 (Fed) 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, as a result of (a) fears of a slowdown in the fiscal stimulus driven growth witnessed in the US over the course of 2018 (b) the ongoing growth drag from global trade disputes and (c) more recently a heightened fear over the likelihood of global recession in the next 12 months.
At these 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 all diversified portfolios should have structural allocations to ‘vanilla bonds’ to add defensive properties, moderate volatility or to hedge liabilities. So, I realise that for a former career fixed income manager to be making the case against structural allocations to bonds must seem heretical, but to paraphrase the song from REM, I have lost my religion.