Focus on multi-asset – Being overweight bonds

It is a common question from allocators to multi-asset managers these days – why are they so overweight bonds when the risk/return profile for the pricey asset class is so asymmetrical?

Many flexible multi-asset managers are, indeed, overweight bonds after prices of core developed world debt neared all-time highs recently on fears including posible break-up of the Eurozone, America hitting its own post-election problems, and a slowing China unable to counterbalance such woes.

Long-dated core Western world debt has rallied recently, but only off sub-2% yields, and rates on 10-year UK gilts remain at their lowest level since 1703.

Over summer, yields on both German and Swiss two-year bonds turned negative, and not even a downgrade of America by Standard & Poor’s could halt appetite for US 10-year debt, which since rose by 11%.

Multi-asset managers who are overweight this class, and determine weightings by expected returns, must explain to allocators why they are still overweight.

The Balanced Risk series of strategies from Invesco Perpetual also has a comparatively heavy 60% bond weighting in its fixed income universe, comprising six developed world regions. Invesco’s portfolio manager and head of investment research, global asset allocation, Scott Hixon explains, the trio of strategies base their allocations first and foremost on the basis of risk.

Each asset class – bonds, equities, commodities – should contribute equally (33%) to total risk, so the fact bonds contribute 25% now means they are in fact underweight on this measure.

The strategies come with targeted annual risk (volatility) of 6%, 8% and 10% respectively, over the business cycle.

The strategies are overweight, in regards risk, for Treasuries and gilts, and underweight sovereigns of Japan, Canada and Australia.

Equities are about 20% of fund assets, but contribute 50% of its risk. And commodities are about 20% of fund assets, and 25% of its total risk.

Hixon explains the reasoning on the bond position: “Volatility declines in the face of rising prices and you have had interest rates falling, which means volatility declines. Bonds are much less volatile than they were 10 or 20 years ago.” (He makes here one important exception, for peripheral European debt).

“When you focus on risk, the lower volatility assets will become a larger proportion of the capital allocation, whereas the higher volatility assets will be a lower proportion.”

He adds, as rates rise, Invesco’s funds will naturally decrease their allocation to bonds.

“What happens to a strategy like ours when rates fall is the bonds become more volatile, so we expose ourselves less to them, and reduce exposure to the risk.”

Focusing first on risk, and not returns, lies at the heart of the three funds, that Hixon and his team run.

He says yields will rise or fall either because of expectations about inflation, or about real growth in the economy.

If rates rise because economies are growing once more, Hixon reasons that equities and commodities – the other two components of his team’s portfolios – should do well, hopefully offsetting any price decline in bonds.

If rates rise because of inflation, then the portfolios’ commodities exposure should respond positively.

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