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Column: The end of bonds as ballast?

LONDON (Reuters) - The days of using safe bonds as ballast for equity-heavy investment portfolios may now be numbered for many investors - though what replaces them is a much more complicated business.

A financial trader works at their desk at CMC Markets in the City of London, Britain, April 11, 2019. REUTERS/Peter Nicholls

As asset managers take stock at midyear of a shocking re-drawing of the investment map in 2020, one of the biggest question marks lies over the traditional role of government bonds in mixed-asset portfolios as a hedge against future equity slumps.

For all the sophistication of modern portfolio construction, the decades-old 60/40 equity-to-bonds idea has been a broad rule of thumb for many long-term institutional investors and individual savers - maximising returns while keeping overall risk in check.

More volatile, higher-yielding equities outperform as the economy grows and safer government bonds do so in a slowdown or recession - gaining sharply in value during business and equity price slumps as official interest rates are slashed and fixed income in demand.

Worrying for those seeking diversification and hedges, returns on both have often risen in tandem over the past decade as slow growth and easy credit have buoyed all assets. But bonds have still typically proven as more than adequate offsetters during bouts of equity turbulence.

Until now that is.

The problem for many investors is the pandemic shock has finally sunken safe bond yields so close to zero that they have no where left to go performance-wise in another downturn over the next 5-10 years.

At least that’s true if you assume zero remains an, albeit rough, lower limit and central banks will, explicitly or not, cap yields close to zero to keep mountainous government debt loads affordable over time.

There are many “ifs” and “buts” in there, but that scenario is an increasingly consensus view and investment advisers at major banks such as JPMorgan, Societe Generale and many others are now saying alternatives to government bonds need be found.

After extensive number-crunching on past and prospective investment performances, JPMorgan’s long-term strategists Jan Loeys and Shiny Kundu told clients this week they should “significantly” reduce holdings of safe bonds given the low return horizon they see over the coming 5-10 years.

“In the zero-yield world which we think will be with us for years, bonds offer neither much return nor protection against equity falls,” they wrote, adding that the 10% per annum returns seen on a U.S. 60/40 fund over the past 45 years will drop to as low as 3.5% over the coming decade.

U.S. aggregate bond indices containing government, asset-backed and investment-grade corporate debt now yield a record low of 1.3% - a little over a fifth of its 44-year average - with just over 1% volatility. And this overall scenario is set to persist for many years.

Since 1985, they found that as bond yields fell, the volatility of annual returns also fell - most likely due to the gravitational pull of zero as yields get closer to it.


What to do? Simply increasing equity relative to safe bonds to make up the return just lifts the expected volatility and risk that many investment managers will baulk at.

And so the JPMorgan team reckon safe bonds should be replaced by what they called “hybrids” sitting somewhere between debt and equity.

Specifically they talk of equity-like bonds and bond-like equities such as high-yield corporate debt, collateralised loan obligations (CLOs), commercial mortgage-backed securities (CMBS), real estate investment trusts (REITs), convertible bonds, and preferred and utility stocks.

Taken together, JPMorgan reckons long-term investors who can see through sharp year-to-year moves, to stay focussed on a decade hence, should consider a 60/40 hybrids/equity split that would raise prospective 10-year returns to about 5% per annum with lower “end of period” risk than 60/40 equity/bonds models.

The crux is that any higher volatility and risk in equity is lessened in these hybrid assets by “mean reversion” of returns over time. “Cross-asset class diversification is nearly dead, but across-time diversification remains alive.”

The recommendation raises several questions - what if bond yields don’t ossify and inflation takes hold?

Or what if the pandemic persists without a vaccine and this economic slump lasts far longer than most currently think?

Although not consensus right now, neither necessarily changes the asset-mix picture as long as central banks - as many expect - keep buying safe bonds to keep government borrowing sustainable.

But if the world’s largest investors heed the advice to exit government bonds altogether, central bankers may have to work very hard indeed to do that.

The author is editor-at-large for finance and markets at Reuters News. Any views expressed here are his own.

by Mike Dolan, Twitter: @reutersMikeD. Chart by Ritvik Carvalho; Editing by Pravin Char