Government bonds used to provide both an income and the prospect of strong positive returns during a recession. Balancing equity exposure with significant government bond exposure therefore became a core tenet of portfolio construction. But today, with such low starting yields, government bonds offer little income or upside potential, forcing investors to rethink their approach to both diversification and income generation.
In the next decade, a traditional euro market 60:40 stock-bond allocation is expected to earn only around 3.5% a year (2021 LTCMA estimate). But many investors require higher yields and higher returns than that from their portfolios.
Seeking higher income
Exhibit 1 shows a range of fixed income asset classes offering income and their correlation with global equities. While higher yields are available to investors prepared to look beyond developed market government bonds, the challenge is building a fixed income portfolio with sufficient yield without uncomfortably increasing the correlation with equities.
Exhibit 1: Investors will need to look across the piste to get the best balance of yield and risk
Fixed income yields
%
Source: Bloomberg, Bloomberg Barclays, ICE BofA, J.P. Morgan Economic Research, Refinitiv Datastream, J.P. Morgan Asset Management. Beta to MSCI World is calculated using monthly total returns since 2008. Indices used are as follows: Euro IG: Bloomberg Barclays Euro-Aggregate – Corporate; Global IG: Bloomberg Barclays Global Aggregate – Corporate; UK IG: Bloomberg Barclays Sterling Aggregate – Corporate; US IG: Bloomberg Barclays US Aggregate – Corporate; Euro HY: ICE BofA Euro Developed Markets Non-Financial High Yield Constrained Index; Global HY: ICE BofA Global High Yield Index; US HY: ICE BofA US High Yield Constrained Index; EMD Corporate: CEMBI Broad Diversified; EMD local: GBI-EM Global Diversified: EMD local – China: GBI-EM China: EMD Sovereign: EMBI Global Diversified; EMD Sov. IG: EMBI Global Diversified IG; EMD Sov. HY: EMBI Global Diversified HY. Data as of 17 November 2020.
Investors may be comfortable shifting a higher proportion of their fixed income allocation towards credit, on the assumption that any downside will be capped by central bank intervention. However, we caution against abandoning a focus on fundamentals. Given the ongoing near-term uncertainties, investors making their first steps out of government bonds into the credit markets may benefit from focusing on the highest-quality segments. We are also mindful that the dependence on central bank support gives rise to risks of taper tantrum-style events of the type seen in 2013.
Chinese government bonds offer one potential solution, with a 2-3% yield depending on duration, next to no correlation with global equities and the potential for long-term currency appreciation. Flexible fixed income strategies with an absolute return objective could also help.
Outside of fixed income, real assets such as real estate and particularly infrastructure can offer more attractive yields in return for low liquidity. While real estate has clearly come under pressure because of Covid, we don’t believe people will be working from home forever, given that one of the key benefits of offices – having everyone in the same place at the same time – cannot easily be replaced. Given office floor space requirement is driven by peak demand, say on a Monday, post-pandemic demand may prove more robust than some fear. Nor will all shopping be done online; however, just as the rise in online shopping creates a challenge for some retail properties, it also creates an opportunity in warehouses.
Core infrastructure has demonstrated remarkably consistent and defensive income streams both during this recession and during the last financial crisis. Given yields close to 7% and the ability to access reliable contracted or regulated cash flows with the potential for capital upside and inflation protection, infrastructure could play an increasingly important part in investor portfolios for those who can access it and are comfortable with the lack of underlying liquidity.
Seeking diversification
While adding higher yielding credit, real estate and infrastructure to a portfolio can help replace some of the income that government bonds used to offer, while still providing some diversification from equities, investors may need to look elsewhere for the kind of downside protection traditionally offered by government bonds.
Of the hedge fund strategies available, macro funds have historically done the best job of consistently protecting portfolios during equity bear markets. While return expectations for macro funds as a whole are relatively low, good manager selection may help to boost returns during bull markets while still providing downside protection during bear markets (Exhibit 2).
Exhibit 2: Macro funds have tended to provide downside protection
Hedge fund style returns during bear markets
% total return
Source: Hedge Fund Research Indices (HFRI), Refinitiv Datastream, J.P. Morgan Asset Management. 2000 bear market is from 31 March 2000 to 31 October 2002, 2008 bear market is from 31 October 2007 to 28 February 2009, 2020 bear market is from 31 January 2020 to 30 April 2020. Hedge fund strategies are defined in the HFRI hedge fund strategy classification system. Data as of 17 November 2020.
Exhibit 3: Adding alternatives may help improve the risk/ return profile of a portfolio
Expected returns and volatility for a EUR investor in coming 10-15 years
% annual compound return
Source: Long-Term Capital Market Assumptions, J.P. Morgan Asset Management Multi-Asset Solutions. Expected returns and volatility assumptions refer to the next 10-15 years. Forecasts are not a reliable indicator of current and future results. Data as of 31 October 2020.
In summary, while government bonds can still provide some diversification, they offer much less income and upside potential than they used to and are vulnerable to a potential pickup in inflation and/ or growth. By adding real estate, infrastructure and macro strategies to portfolios, investors may be able to increase both their risk-adjusted income and returns relative to a traditional stock and bond portfolio (Exhibit 3).