“The 2008 crisis has blown holes in modern portfolio theory,” says Saker Nusseibeh, CEO of Hermes Fund Managers. “Western nations will have to devalue their currencies in order to get rid of debt because of the magnitude of the problem. Investors are also beginning to realise developed market sovereign bonds are not risk free. Since the 50s there has been a belief they were, so the question of risk on/risk off was just about allocating more or less to those bonds. It is laughable to think bonds are risk-free. The US and UK have effectively defaulted on the Panama and War Loans respectively in recent times. That doesn’t mean they are not safer than equities, but there are different degrees of risk. Because people are dumping the idea of bonds as risk-free return, their correlation to equities has fundamentally changed and won’t go back to the old norms.”
There may also come a day when institutions’ behaviour changes the dynamics of the bond/equity correlation. An environment of rising yields as QE ends and improving economic conditions for equities, means better funding ratios. Many defined benefit schemes are expected to lock-in those gains by buying into inflation-linked bonds as yields reach trigger points, supporting valuations.
“At a certain yield, we could see a wave of buying from DB pension funds looking to de-risk,” Old Mutual’s Lebleu says. “That will compress yields above and beyond the expectations of central banks and change the course of monetary policy. Pension funds have to do this and it could mean negative real yields even at much higher nominal yield levels if nominal yields are compressed by DB fund-buying whilst inflation is rising. That would potentially be very stimulative for the economy.”
Should that trend materialise in a meaningful way, bonds and equities would no longer move in opposite directions but rather share directionality while having different risk parameters.
The end of the affair
Much has changed since 2008, not least the dynamics of the relationship between bonds and equities. While many expect the traditional negative correlation to resume as central banks begin to end quantitative easing, the relationship is fundamentally different given the extent of central banks’ balance sheet expansion and the recognition among investors of the risks associated with a highly levered West.
In their desire to de-risk, institutions themselves may contribute to the breakdown of a relationship that has sat at the heart of asset allocation for many decades. While developed Western sovereign bonds are still largely less risky than equities, the extent to which they can provide a hedge is much more nuanced than pre-2008.
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