By Peter Westaway and Charles Thomas
Most institutional investors realise that over the next decade, bonds are likely to produce low returns relative to their recent history and the most likely path of equities. But the most likely path isn’t certain and equity markets carry more risk and volatility.
If the so-called “bond bubble” bursts, yield curves would likely shift upwards, inflicting capital losses. To guard against this, many investors are inclined to abandon bonds, or restrict themselves to short-dated bonds to manage duration risk.
But we would caution against abandoning bonds. We urge investors to remember what role they play in the portfolio. We believe the risk management function of bonds should not be ignored. Bonds should continue to play an important strategic role in long-term balanced portfolios, starting with a broadly diversified and market weighted allocation.
While there may be good reasons for avoiding long-dated bonds, remember that an upward-sloping yield curve already reflects the expected path of rising interest rates, so playing different parts of the curve may not pay off as hoped.
Given the outlook, many investors may be tempted to rotate into equities to improve their expected return. But investors should remember that shifting out of bonds carries risk. The trade-off between risk and return gets to the heart of the case for holding bonds.
Bond return volatility has been 10 to 17% lower than that of equity returns in the UK, US and Germany over the past 30 years and thus provides a useful dampener to equity risk.
Bonds also tend to offset equity returns during when equity prices fall. This negative relationship suggests that, if bond returns fall, it could happen when equity returns are rising.
No one can be certain that this negative correlation between equity and bond returns will apply in all periods. And historically low interest rates inevitably limit the scope for further falls in bond yields. Even so, the argument for providing some risk mitigation to a pure equity portfolio still has merit. No one knows the future path of equity markets, which could easily succumb to a European sovereign debt crisis, a hard landing in China or renewed concern over the US fiscal position. In any of these cases, bonds would serve their traditional role as a portfolio anchor and counterbalance to risky assets.
Some investors are tempted to offset the lower returns of bonds by moving down the credit spectrum in a search for yield. This might increase yield, but would inevitably boost the risk and volatility compared to a broadly diversified bond allocation.
Our analysis shows that substituting a broad bond allocation for a higher yielding asset class reduces its ability to perform its traditional risk reduction role.
An excessive focus on yield may cause the investor to under-appreciate the additional risks of striving for that yield. An overweight to riskier fixed income sectors or high yielding asset classes should be evaluated the same way as a decision to increase a long-term equity allocation in pursuit of a higher return objective, with the investor’s goals, time horizon, and risk tolerance being the key factors driving this decision.
Peter Westaway is chief economist, Europe and Charles Thomas is an investment analyst at Vanguard Asset Management
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