After years of being overlooked, are bonds finally regaining their place in multi-asset portfolios?
We believe bonds always have a place as a core investment in multi-asset portfolios, but with hindsight there were plenty of reasons to hold back in the past few years. Philosophically we like to think in terms of risks and scenarios. Scenarios can be imagined, preferred, but eventually we can face a multiplicity of scenarios in the future, and we must accept that forecasting or timing them is an impossible task. If we think back to six years ago, who planned for COVID-19, the inflation shock, or this trade war?
Meanwhile we know that similar scenarios, often variations of the past, will happen again and will trigger growth and inflation and liquidity shocks – up or down. We look at the progressive evolution of a variety of indicators on a daily basis and some data for bonds has improved recently: risk indicators are normalising, trend indicators are stabilising, valuation indicators are getting more attractive.
At the same moment, risky assets reach hot levels, higher valuations for equities, tight spreads for credit, the macro picture is still relatively solid but cracks and tensions appear. This justifies neutralising bonds at the least and waiting for more confirmation to turn outright positive.
How should multi-asset investors approach bond exposure in the current environment?
Diversity is the keyword, and I would recommend to not necessarily follow market cap indices as they are often too concentrated. We should remember that bond indices are more concentrated in those countries that have more debt, which is somewhat counterintuitive from a risk management standpoint. Investors should remain aware of home biases too and it may be worth exposing to a broader universe, even if it may involve some currency hedging.
When it comes to the implementation of our portfolios, our preference is for highly liquid instruments and we trade major bond futures such as 10-30 year bonds, while we trade credit separately through index CDS in order of have a better hold of duration and credit risks separately. These can also be used as overlays on a cash bond portfolio to increase agility and efficiency.
Sizing exposure should remain dynamic, and we don’t believe it is sound to calibrate a portfolio exposure on the basis of a single scenario preference. As I mentioned, we prefer to look at a variety of indicators and acknowledge their progressive confirmation of an improvement, locally or globally, which may guide also regional allocations.
How is the correlation between bonds and equities evolving, and what does this mean for diversification?
That’s a hot topic! As risk-based investors, we have always looked at correlation measures with some kind of suspicion. First, we like to evaluate correlations in terms of long-term regimes. Correlation evolution tends to be influenced by aggregate macro indicators like growth and inflation, while monetary policies obviously may have an impact.
We often hear that negative correlation is gone and diversification doesn’t work anymore, but it is important to note that correlation has been positive in the past, like in the 70s and 80s. It may be that the 2000-2020 period was the anomaly. What matters more is whether correlation would spike in a recessionary scenario for example, this would be an indication of ‘something new’.
Also, sometimes we observe a positive correlation that is actually good: remember 2019 when all assets were rising together, that was a particularly good year for cross asset portfolios. To manage the risk of positive correlation in downward markets, such as 2022, we believe other tools should be considered, such as including diversifying assets like commodities, tail strategies across both rates and equities, and ultimately, what we call drawdown management techniques that care about sizing exposures dynamically. Ultimately there’s not a one-size-fits-all portfolio as we know and we must have the variety of tools and techniques to adapt to changing conditions or maybe to a ‘this time is different’ scenario.
What trading opportunities could emerge as bonds regain diversification potential?
It depends on the global markets path looking ahead. Short-term, redeploying capital across high quality bond markets is a way to maintain your exposure to risky assets and enjoy the ride, while implementing a better portfolio diversification and hopefully something to help in case of macroeconomic deterioration. Eventually it is all about trying to preserve capital of your portfolio and have more capital to redeploy into risky assets when valuations get more reasonable and credit spreads more generous.
The real challenge is, as we know, that bull market conditions can last much longer than we expect and there is potentially a high cost of staying on the sidelines. We should also keep an eye on rates curves, the 10-2 has steepened a bit across major blocks, usually close to 0.5%, which is now not far from the long-term average of 1%, but still far from the 2% levels that we have typically reach before major turning points that were more supportive to risky assets long-term returns.
Ultimately, it is important to remember that diversification helps stay fully invested while valuations start to look frightening. And even more so as no G10 central bank is giving any signs that it is willing to hike rates!