Willem Sels, UK head of Investment Strategy at HSBC Private Bank, believes that alternative investments will gain in attraction as bond markets become increasingly challenged this year.

Safe haven bonds have become more volatile and are likely to suffer from gradually rising yields this year. Investors still want portfolio diversification in case equity market volatility picks up, but are looking for a cheaper alternative to bonds. We believe that alternative assets can provide some degree of diversification, income and safety - three roles traditionally played by bonds. Valuations of alternative assets are not as stretched as in the bond market in our view, and future returns may hence be more attractive.

In our view, bonds play an important role in portfolios, as they fulfil three essential roles: 1) predictable income, 2) relative safety (depending on the credit quality and default risk) and 3) diversification. We cannot help thinking that everything comes at a price, though, and the current historically low yields of safe haven bonds make them unattractive, in our view.

On the two other issues - safety and diversification - bonds still score well, even if the record is being challenged. Credit risk can still be limited by focusing on solid sovereign or corporate issuers. Nevertheless, increased market volatility and the asymmetric risk for yields (more upside than downside) challenge the ‘safety' label, in our view. Finally, as we will show, we think bonds have lost some of their punch as a diversifier: with yields already near historical lows, it gets increasingly difficult for bonds to rally enough to offset any losses on equity investments.

In summary, one could say that the insurance offered by bonds is less powerful than it was, and comes at a much higher premium. We thus look for alternatives to complement our gradually declining bond holdings, and it seems that we are not the only ones. US pension funds have been adding to their real estate exposure and last week, the Norwegian petroleum fund announced it has entered the US real estate market for the first time. Late last year, some major US university endowments boosted their investments in hedge funds as they look for relatively stable returns and portfolio diversification.

Of course, no asset class is perfect, and none of the alternatives listed in the table below perfectly fulfils the three traditional roles of bonds. Diversification benefits may well continue to be lower than those of bonds, and liquidity varies, but better return prospects mean that, in our view, most portfolios should benefit from adding a combination of different alternative assets.