Bonds still have a role to play

Despite economic uncertainty, defensive assets can provide diversification benefits

In the vein of keeping things simple, if you had to choose three asset classes for your portfolio we believe it would come down to shares, fixed interest (bonds) and cash.

This way the portfolio construction balancing act oscillates between risk-on (equities) and risk-off (fixed interest and cash) strategies, given prevailing market conditions and future expected returns.

Theory states equities and bonds are negatively correlated – if one goes up, the other should come down, which highlights the benefits of holding these asset classes in a multi-asset portfolio. But it’s not uncommon for both asset classes to deliver positive returns over the same time, as was the case in 2019. Granted, they were both going up for different reasons.

Do bonds still provide diversification benefits? The short answer is that over the past decade, long-term global sovereign bond yields have collapsed, driven by the monetary policies employed by global central banks.

Since November 2006, the declines in 10-year government bond yields for key developed markets were as follows: Australia -4.7%, US -3.9%, Germany -4.1%, Japan -1.7% and UK -4.3%. These are big movements considering a +/- 0.2% movement in yields is considered meaningful in bond markets.

This downward trend has in turn given stellar returns to bond investors in the form of capital growth. But the yield backdrop is such that some developed market bond yields are close to zero or negative. So how low can bond yields go and are yields more likely to rise, which could result in significant capital losses?

In our view, bonds still have a role to play in multi-asset portfolios. There remains significant uncertainty at the macroeconomic and geopolitical level, which will likely see investors still gravitate towards the sector for its defensive qualities. This was evident in the recent virus-induced market sell-off, with Australian government bonds providing a solid positive return over the first half of 2020 while the S&P/ASX 200 Index was down 10.4%. Looking forward, monetary policy remains extremely accommodative with little signs the global central banks are going to pull back. This will likely provide a level of ceiling to bond yields.

In this environment, investors will be better served seeking long bond positions in developed markets where yields are still positive. This includes Australia and the US. The key down risk to using bonds as a diversification strategy is higher inflation but this is not an immediate risk.

Zach Riaz is an investment manager and director at Banyantree Investment Group, with responsibilities across equity and multi-asset strategies. See banyantreeinvesmtmentgroup.com