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Are bonds still sufficient diversifiers?

David Brenchley  |  09 May 2018Text size  Decrease  Increase  |  
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chain link breaking, bonds, equities, correlation, diversification

One of the biggest risks facing investors today is the potential for the equity-bond correlation to decouple, according to Sebastian Lyon, chief investment officer at UK-based fund manager, Troy Asset Management.

For decades, bonds have been the perfect portfolio diversifier, providing protection from sharp equity market falls. The two asset classes have been perfectly negatively correlated for the past 35 years, meaning if the latter fell in value, the former would appreciate.

But February’s equity market correction coincided with a simultaneous drop in the bond market. As equities took a downward turn, so did bond prices. As a result, the yield on the US 10-year Treasury bond breached 3 per cent for the first time since 2014.

With yields on both equities and fixed interest instruments at such low levels, Lyon worries this will continue to be the case in the future. The traditional 60 per cent, 40 per cent equity-bond barbell portfolio strategy may not work in the future - a concern he shared with delegates at the Morningstar UK Investment Conference last week. 

The rise in the US bond yield is also troubling from a portfolio construction perspective, particularly in times of ultra-low yields and high valuations across the board. "People are rightly concerned about the US bond yield because all assets that generate income are priced off it," Lyon explains.

"Whether that be equity, property, credit ultimately everything is priced off Treasuries. And if we are at the end of this 36-year bond bull market as some suspect, it has huge implications for such asset prices."

For his part, Lyon reckons there’s "one last fall in the bond yield before we really see a major bear market in bonds".

"But I wouldn’t necessarily be investing strategically on that basis because we’ve been in a bull market for such a long time and I’m concerned about those correlations."

An absence of value

A decade of cheap money since the end of the financial crisis has led to the third bubble for asset prices in 20 years. As a result, such prices "need to be taken with much circumspection", Lyon says. This is worrying for investors because there is currently an absence of value in markets.

"Back in 1999-2000, there were ways of hiding your assets in non-tech companies," Lyon says. "You could buy value companies, you could buy bonds; there were an awful lot of areas you could hide and protect, if not grow, capital following the dotcom crash.

"Similarly, during and post the housing bubble, there were also places to hide, whether it be in fixed interest, whether it be in gold, whether it be in currencies, particularly in the US dollar.

"But in this cycle, all assets have risen, so it’s going to be much harder on the downside to protect capital. There aren’t nearly as many places to hide."

The cyclically adjusted price/earnings (CAPE) ratio is currently running at levels seen only two other times in the last century. The Shiller PE peaked at 32 times in 1929, shortly before Black Tuesday; in January 2018 it reached 35 times.

While there’s every chance it could go higher – during the dotcom boom it hit over 40 times – "from those levels, returns were generally pretty poor". For this reason, the equity-bond correlation we have historically seen is worrying.

Where to invest?

Lyon says overvalued assets with low prospective returns means investors have been forced to reach for yield. This has, in turn, meant they’ve added risk to their portfolios. The manager thinks this is a mistake, and says his fund has a relatively low allocation to risk.

"Our emphasis is on quality in equities, short duration, index linked and liquidity. We will not be picking the proverbial pennies up in front of the steam-roller."

Another UK-based fund manager, James Clunie of Jupiter Asset Management, shares Lyon’s worries. "I think these are exceptional times in markets," he told the conference. He says the winners in this environment have been those that have taken risks, and reached for yield.

Clunie admits that an absolute return strategy is not suited to this environment. However, he claims, the ability for a fund manager like himself to short certain assets will be a handy diversifier for investors’ portfolios in these times.

A portfolio whose short positions matched, or even exceeded, its long positions would profit if the market fell, says Clunie. Uniquely, it could also have a negative duration. This would, in turn, lead to a low or negative correlation with other assets.

"That low or negative correlation can be really useful for investors because if you’ve got something that is negatively correlated you know that’ll bring down your overall risk if you blend it into a suite of funds."

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David Brenchley is a reporter for Morningstar UK.

© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.

is a Reporter for Morningstar.co.uk.

© 2020 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

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