Choose Your Poison: Default Risk Or Duration Risk

One of the most frequent questions multi-asset investors get asked is can bonds continue to offer the diversification benefits upon which traditional equity-bond portfolios are founded?

Over the past 30 years, a ‘60/40’ portfolio has delivered strong risk-adjusted returns. However, after interest rates were cut to almost 0% in response to COVID-19, UK Gilts yield 0.2% whilst US Treasuries yield a slightly less miserly 0.7%. If US yields were to fall to 0% investors may get a capital return of 7% or so but what then? During the COVID-19 sell-off, German and Japanese government bonds, which yield -0.5% and 0.1% respectively, were flat.

Does the same fate await US and UK bond investors?

Well, this week one of the world’s largest asset managers, known predominantly for its passive funds, hosted a webinar on this very topic - the future of bonds. The fund house in question concluded that sovereign bonds could no longer offer the same returns upon which the traditional 60/40 portfolio was founded.

Instead, it advocated the virtues of higher yielding investment grade corporate bonds – the highest rated part of the corporate bond universe. Such a move – selling government bonds to buy bonds issued by companies – increases the credit risk of portfolios, so the risk that the issuer defaults on its debts. Worrisomely, it does this more than investors may realise: around 40% of UK, US and European investment grade corporate bond markets are invested in BBB-rated securities. These are securities one notch away from being considered ‘junk bonds’.

A second option…

If this sounds unpalatable, there is a second option. Rather than increasing default risk, investors can choose to own government bonds with a maturity further into the future, e.g. own a 20 year bond rather than 10 year one. These bonds are still backed by the full faith and credit of governments but have slightly higher yields. The issue with these bonds though is investors are increasing their duration risk. This is the risk that should interest rates rise, these longer duration bonds fall in value more than shorter duration issues. Interestingly, duration has in fact risen for most UK government bond funds.

Both options could be an unpalatable choice for investors. However, there are alternatives to bonds, which can rally when equities fall irrespective of whether bonds go up or down. Whilst past performance is not a guide to future returns, this is precisely how some “alternative funds” performed during the Coronacrisis. Investors may wish to consider allocating part of their portfolios to this asset class.