Fixed income is traditionally thought of as the asset class that provides downside protection during an equity market correction. But do bonds really give this protection when investors need it most?
“Diversification the way we typically think about it is a myth,” said Sebastien Page, head of asset allocation at T Rowe Price, participating in a panel discussion at the Expert Investor Pan-European Congress in Rome last Wednesday.
Page has done some research on the matter in the past, and found that geographical diversification indeed works, but only if equity markets go up. “Correlations tend to go up and down with markets,” he said.
Page found a slight correlation between US and non-US equities during periods when equity markets went up by more than a standard deviation, using a data sample spanning several decades. However, in strongly downward markets correlations go the other way, reaching a positive correlation of 76% in periods when markets are down by more than a standard deviation.
“In the past you had cushion from your coupon that gave you some protection, but with yields so low, that has also stopped,” Tim Peeters, head of securities portfolios at the Belgian multi-family office Portolani, added grimly.
The stock/bond interplay
Sometimes, however, stocks and bonds are good diversifiers. That was for example the case in the aftermath of the dotcom boom until the global financial crisis unfolded in 2007, notes Page.
But what factors drive the correlations between stocks and bonds?
“I would say that you should expect a positive correlation if concern about rates dominates markets. If inflation concerns are absent and if the business cycle dominates news, expect bonds to be a good diversifier, though the problem is now of course that bond yields can’t go much lower even if equities are hit.” At this point in the cycle, therefore, bonds can offer some capital protection at best. They are unlikely to provide any compensation for losses on the equity side of your portfolio.
So, if bonds are not (anymore) the fortifications that help you weather a storm, how can you weather-proof your portfolio instead? Commodities such as gold are one of the building blocks you can add. As Peeters puts it: “Not to invest in gold now is like reading a playboy without any pictures.”
“You can also work with multi-asset funds with low volatility, and add long/short equity funds to your portfolio,” Peeters added.
And, last but not least, numerous alternative asset classes have sprung up within fixed income over the past few years: such as catastrophe bonds, mortgages, loans and microfinance. Although they are often less liquid than mainstream bonds, such strategies tend to couple higher yields with a lower correlation to mainstream fixed income and equity markets.
Read everything about fixed income alternatives in the March edition of the Expert Investor magazine, out now.