As a consequence of the historically low yields offered by developed market government bonds, the traditional role of duration as a natural counterbalance to equity beta is less efficiently working for multi-asset managers today.
The low yield levels available in renowned ‘safe haven’ government bond markets – as evidenced by a 10-year German bund yield of just above zero – additionally bring sizeable drawdown risks, with any move higher in yields likely to result in considerable capital losses for long-maturity bondholders.
Many multi-asset strategies have struggled during the market volatility this year because managers are failing to address this new fixed income paradigm and cannot identify truly defensive (anti-beta) assets. Many managers look to de-risk a portfolio and limit drawdowns either by buying expensive protection overlays, or try to time the market. This approach leads to inconsistency and proved to be insufficient for most diversified growth strategies during the severe drawdown and subsequent rebound in Q1.
Look to low-risk equities and currencies
Instead of relying on the notoriously difficult task of repeatedly making accurate macro calls, multi-asset managers need to find alternative solutions to fill the role traditional duration can no longer fully serve.
One substitute way of protecting downside other than simply using high-quality government bonds is to use high quality low-risk equities. Low-risk stocks, those with robust fundamentals and more resilient earnings, tend to behave much better than overall global equities during negative market periods – as witnessed during the global growth scare at the beginning of this year. This outperformance can help protect a portfolio and compensate for the lower protection offered by duration. For example, stocks such as Verizon and Infosys rose by 7% in January, in a month where global equity markets plunged more than 10%.
Additionally, a currency overlay strategy based on PPP (Purchasing Power Parity) principles has also been proven to display anti-beta behaviour. We select highly-liquid G10 pair trades on two main criteria. Firstly, trades are analysed for correlations with S&P and HY indices, to ensure the positions can offer protection during stressed periods. Each pair trade also has to be undervalued on PPP principles, to ensure the diversification benefits will persist going forward. For example, a long JPY/ short GBP pair trade was able to return more than 10% during the volatile first quarter of 2016.
Avoid bunds for duration exposure
Despite these alternatives, duration can still play a role in the construction of multi-asset portfolios. However, investors must find duration premiums offering attractive risk/reward characteristics, as well as decent protection in risk-off environments. Which high-quality government bonds offer the highest level of protection and the most attractive expected return? Considering where yields are on both sides of the Atlantic, the obvious answer is the UK and US. Both UK gilts and US treasuries offer a higher buffer – with yields between 13-17x higher than German bunds – as well as a higher coupon to compensate mild increases in yields if rates were to move higher slightly.
Another area of fixed income currently overlooked by investors is covered bonds. This market offers a similar level of safety as sovereign debt, but with an attractive yield pick-up. While European covered bonds are benefitting from the evolving banking and insurance regulation frameworks, it remains an inefficient market able to be exploited by experienced investors in this space.
Finally, with traditional asset classes displaying sharp volatility this year, many investors may be tempted to seek alternative assets to counterbalance the equity beta. However, real assets – areas such as infrastructure, private equity and real estate – often suffer from illiquidity and are artificially lowly-correlated to traditional betas like equities. Efficient diversification is not simply about piling a number of asset classes, but rather the identification of a select number of truly uncorrelated positions able to deliver for investors through all market environments.
Claus Vorm is manager of the Nordea 1 – GBP Diversified Return Fund, otherwise known as Nordea 1 – Stable Return Fund in other parts of Europe