No asset has divided opinion in the investor community over recent years like government bonds. For many asset allocators, the government bond market has been an asset class in the midst of giant bubble and one to avoid. For others, it has been one of the few asset classes to exhibit a negative correlation to equities and thus a necessary constituent of a multi-asset portfolio, no matter the price.
Even at a retail level, many defensive investors can be left puzzled when the bottom-line of their portfolio falls. For example, a portfolio that is traditionally structured with 20% in equities and 80% in fixed income is thought to be cautious, so investors will naturally find it hard when bond prices fall. So, where are the protective benefits and what are the Morningstar Investment Management team doing to protect investor capital?
Why Own Government Bonds?
Sudden shifts in bond markets are inevitable from time to time, although one can never be sure what the catalyst nor sustenance will be. While we cannot draw strong inferences from this price volatility, it does provide a timely reminder that bond markets are not always as defensive as some believe them to be.
In this regard, it is important to establish a few truisms before delving into our take on effective ways to protect capital and deliver sustainable long-term returns.
First, as a general rule, long-term government bonds tend to be negatively correlated to large-cap stocks. There will be periods when the two asset classes move together, such as in the taper tantrum of 2013, but over the long term, they will tend to move in opposite directions. This is an extremely powerful tool for asset allocators. Combining asset classes with negative correlations can provide investors with superior returns and help dampen the volatility of the overall portfolio.
Second, “defensive assets” are more than just government bonds. While it is tempting to look solely at the relationship between stocks and bonds, portfolio construction is multifaceted and valuation dependent. Therefore, it is important to consider the full spectrum of assets at an investors disposal, as everything from cash to telecommunication companies can be useful in offsetting certain risk factors and ultimately improving reward for that risk.
Bond Market Malaise
For every asset class, Morningstar generates what we consider a fair value based on our long-term analysis. These are calculated by discounting the asset’s cash flows at a discount rate commensurate to its risk and uncertainty. Current values are then compared to their fair value to identify expensive assets to avoid and cheap assets to own.
This is an intuitive approach that uses fundamental building blocks. While this is far from a perfect science, we believe one can build a more realistic framework about where yields could go in the long-term by incorporating central bank inflation targets, a conservative assessment of real yields and evaluating the shape of the yield curve.
While our assessment of long-term yields varies by country, they are still considerably higher than current levels. In the U.K. for example, our fundamental approach leads us to expect nominal long-term yields in the vicinity of 4-5% based on current structural considerations, compared to current levels of approximately 1.5%. By its very nature, this is not conducive to strong performance because prices will likely fall if yields revert to 4% or higher.
One of the beauties of bonds is that we know the starting yield. In the absence of default by the bond issuer, we know the return over the lifetime of the individual bonds. It is these paltry yields that have prompted the investment team at Morningstar to reduce our government bond allocation, continuing the trend we have been following for several years.
What has become increasingly clear is that as a standalone investment, locking in yields at these levels only really make sense in a world of deflation and negative economic growth. Therefore, it is natural to ask a few questions. For example, does it make sense to hold an investment that may not appreciate in value over the long term? What risk is it intended to offset?
Maximising Reward for Your Risk
We have absorbed a lot of talk about bond bubbles and what the fair value of a bond should be. Without getting caught in the hype, it requires us to think about the total expected return of a bond, but also the role it could have in the event of a market demise.
It is these more fundamental considerations that an investor must wrestle with. For example, we know that short-term forecasting is fraught with danger. Making economic predictions about the impact of Donald Trump’s fiscal proposals, then extrapolating how that affects US demographics and growth has only tenuous connections with making long-term estimates on inflation, real rates, default risks, bond issuance and so on.
There is simply too much scope for error. Similarly, using recent history is fraught with problems. The bond market dynamic has changed so significantly over time and it makes little sense that recent history will repeat itself in this regard. For example, in 1990, inflation was high, central bank balance sheets were small and debts were low – today the opposite is true.
What is the Intelligent Response?
We advocate taking a step back from all the volatility and consider two important concepts. First, the key is whether the market is fundamentally cheap or expensive. This is an assessment of whether the yield is high enough to sufficiently account for default, liquidity, inflation and currency risk. The second concept is to understand how to position it in portfolios. We need to think about sizing and ways to maximise the diversification benefits in such a manner that will ultimately reduce the risk of a permanent loss of capital.
As we do so, we find that emerging market debt and U.S. Treasuries stand out on a relative basis, although the former undoubtedly needs to be acknowledged as a less predictable part of fixed income markets. While we challenge the notion that risk equals volatility in a long-term context, it is nevertheless important to recognise the unique and sensitive nature of defensive assets.
