Looking beyond bonds for diversification and income
Earlier this year, more and more clients began asking why they should bother owning high quality fixed income in their portfolios. Nominal yields were paltry, real yields were hovering around zero, but return targets still needed to be hit. Fast forward to the present, and the need for high quality fixed income in portfolios has become increasingly clear–from the stock market peak on February 19 to the low on March 23, the S&P 500 declined by 33.8% while a 60/40 stock-bond portfolio declined by only 20.9%. Furthermore, core fixed income declined just 0.9% (based on the Bloomberg Barclays US Aggregate Bond Index), highlighting the diversification and protection that high quality fixed income can provide (Exhibit 1).
Exhibit 1: Fixed income helped stabilize portfolios in the recent market downturn
Rebased to 100 on 12/31/2019
This reinforced what we already knew about dynamics in the bond market—you can find protection without income, or income without protection. What we struggle to find, however, are assets that provide both. We define assets that provide protection as those that exhibit a negative correlation with equities; in other words, they zig when the stock market zags. At the end of the day, there is no real substitute for the protection provided by assets like U.S. Treasury bonds; unlike cash, they can appreciate during periods when equity markets are under pressure. While we do not anticipate negative rates in the U.S., the experience in Europe suggests that this protective dynamic holds even when rates are below the zero bound.
However, low or negative starting yields do mean that the protection afforded by core fixed income is constrained and more duration has to be held in notional terms to diversify an equity position (Exhibit 2). Low rates and a changing policy mix reflecting an increased willingness to generate higher inflation outcomes make it unlikely that bonds will afford the same degree of protection as they did in the last cycle. As a result, diversifying the sources of protection in a portfolio is key, as investors can no longer rely solely on bonds to play that role.
Exhibit 2: In a low yield environment, a higher hedge ratio is needed to minimize portfolio volatility
Volatility-minimizing hedge ratio
How can investors add both protection and income to portfolios?
The dwindling ability of bonds to act as a diversifier has implications for portfolio construction. First, it implies more prudent risk taking. One way to accomplish that is by using instruments directly supported by central bank purchases, such as investment grade bonds within high quality sectors. Although these assets are still positively correlated to equities, the beta to risk markets is somewhat mitigated by robust central bank purchases. Second, as the ability of bonds to provide portfolio ballast weakens, investors are forced to source other assets to diversify risk. The increasing use of commodities (e.g. gold) and actively managed foreign exchange (e.g. JPY, CHF) can help to enhance diversification within portfolios (for more details, see the 2020 Long-Term Capital Market Assumptions theme paper: Rethinking Safe Haven Assets). Third, and finally, we expect portfolios to steer more toward secular opportunities like renewables and technology adoption. Real assets with reliable, noncyclical income streams, such as data warehouses and logistics, are likely to receive renewed attention from asset allocators.
With the global economy under pressure, concerns around the ability of real assets to continue generating attractive streams of income have come to the forefront. However, painting with broad brushstrokes is dangerous, as not all assets are created equal. Starting with infrastructure, assets that are more sensitive to the business cycle, such as airports and shipping terminals, will see the greatest impact from the current slowdown. On the other hand, regulated utilities are obligated to maintain service, whereas any issues with contracted assets will be a result of changes in counterparty risk. The same can be said about transportation, where portfolio structuring will make or break the ability of a fund to navigate this period. Finally, on real estate, trends that were in play prior to this lockdown have likely been accelerated—this means further headwinds for retail, tailwinds for industrial and an office sector that remains firmly in flux. The good news here is that investors have more choices for building protection and resiliency into their portfolios than before (Exhibit 3).
Exhibit 3: Alternative asset classes offer protection and income when other asset classes may not
USD quarterly total return correlations (June 30, 2008-September 30, 2019)
Where do investors go from here?
The current recession and its disinflationary pressure will likely keep bond yields low, but we do not expect negative interest rates in the U.S. given the mixed results of this policy’s ability to strengthen economic growth and the money market fund industry. Instead, forward guidance, yield caps and quantitative easing are the preferred tools for supporting the U.S. recovery; together, they should help keep rates low. Looking ahead, we expect expansionary fiscal policy to be a permanent feature as the global economy emerges from the recession. There is simply no appetite for renewed austerity. As a result, we expect both monetary and fiscal policy to remain expansionary into the recovery (in stark contrast to the post-global financial crisis period). If executed properly, this should improve long-run potential growth and increase neutral policy rates, which in turn would lead to steeper yield curves over time.
Low rates leave investors in a bit of a predicament, and as a result, the way we think about building portfolios needs to adapt. Increasingly, investors will find themselves paying for protection while relying on investments with a positive equity beta for both growth and income. This, over time, will likely increase demand for the uncorrelated streams of income that core real assets can provide. However, even these investments may fall short of providing the diversification benefits that are available in the sovereign bond market, highlighting just one of the many challenges facing asset allocators going forward.