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Even in an equity rally, bonds have a role to play

22 November 2017 | Portfolio construction

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Commentary by Aiden Geysen, senior investment strategist with Vanguard’s Investment Strategy Group in Melbourne, Australia.

Sails on a ship

As investors, many of the decisions we make to structure and manage our portfolios can be borrowed from our life experience. For instance, if you're sailing a boat and the wind changes, you need to re-trim the sails, or even change course.

Changing strategy to suit prevailing conditions can make perfect sense. However, when it comes to investor behaviour, the action that makes the most intuitive sense may actually be counterproductive to achieving our long-term goals.

This prolonged period of easy monetary policy to combat low economic growth and inflation has resulted in a multiyear equity rally and bond yields falling to near record lows.

Perhaps unsurprisingly, many investors have shifted away from bonds and increased their exposure to equities. There are also many who are driving up their exposure to cash and alternative investments such as real estate. But cash and alternatives have different characteristics, and their risks should be understood before setting such a course.

The role of bonds

A diversified exposure to high-quality bonds plays an important role in a portfolio, providing a buffer against periods of equity market volatility. Bonds can also be an effective inflation hedge over the longer term, with expectations for higher inflation reflected in higher bond yields.

It's worth exploring whether these relationships are still relevant under the extraordinary conditions that exist today, or whether 'this time is different'.

A popular contention exists that with the low bond yields on offer today, the correlation benefit that has existed between shares and bonds no longer applies. There is little evidence of this, with low- to-negative equity and bond correlations holding throughout this period of very low yields.

The rise in bond prices and corresponding fall in equity prices during the Brexit vote provided us with a practical example of the benefit of holding high-quality bonds in the portfolio. Japan provides us a more enduring example of the persistent relationship between bonds and stocks during a multi-decade period of low yields.

For example, the rise in bond prices and corresponding fall in equity prices immediately after the 2016 Brexit referendum in the United Kingdom provided a practical illustration of the benefit of holding high-quality bonds. Japan provides a more enduring case study of the persistent relationship between bonds and stocks during a multi-decade period of low yields.

The equity/bond relationship holds truest for a portfolio with broad diversification across both bonds and equities. In the case of bonds, a mix of maturities and debt types can help keep a portfolio balanced as conditions change, sometimes rapidly.

Is cash really king?

While cash may also display a low correlation to equities, unlike bonds, cash is better suited as a short-term vehicle for liquidity or savings rather than a longer-term investment.

Despite the environment of low bond yields, longer-dated bonds still provide investors with additional compensation over and above the cash rate, which is referred to as the term premium. While bonds can experience low-to-negative returns in the event of rising rates, the reinvestment of a higher coupon and the benefit of compounding means that investors with a medium-to-long timeframe are eventually better off holding bonds, even under a rising rate scenario.

This function provides bonds with protection against rising inflation over the longer term. Holding cash can also cost investors potential gains in the event of further falls in yields, as unlike bonds, there is no corresponding price increase.

Understanding alternatives

Another often prescribed substitute for bonds in the current environment is alternatives, which is a broad category comprising anything from hedge funds to short-dated credit or real assets, including infrastructure or real estate.

While many of these investments may have lower exposure to market risk, they introduce other characteristics to the portfolio, such as liquidity risk, lack of transparency, complexity and alpha risk – the risk that comes when an investment's return depends on the skill of a manager or investor rather than on the performance of the market as a whole.

This doesn't invalidate the place of alternative investments in a portfolio, although investors need to understand the implications for how each of these risks is likely to impact the portfolio under different scenarios. During periods of equity market stress, alternatives are unlikely to provide the kind of protection afforded by bonds.

While there are many valid ways to build a portfolio to meet an investor's unique goals, much of the anxiety relating to bonds is unwarranted. When it comes to sources of portfolio diversification, bonds remain valid for investors with a medium-to-long timeframe.

Even in the unusual market environment that exists today, before embarking on a different course, investors should consider the potential risk-and-return implications that may come from a strategy to overweight cash or alternatives. While these asset classes can play a role in a portfolio, the best strategy is one that stays on course in all conditions.

Aidan GeysenAidan Geysen
Senior Investment Strategist, Vanguard Investment Strategy Group

Important information:

This article is directed at professional investors and should not be distributed to, or relied upon by, retail investors.

This article is designed only for use by, and is directed only at, persons resident in the UK. It is for educational purposes only.

This article was produced by The Vanguard Group, Inc. It is not a recommendation or solicitation to buy or sell investments.

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not a reliable indicator of future results.

The material contained in this article is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.

Opinions expressed in this article are those of the author and may not be representative of Vanguard Asset Management, Ltd.

Issued by Vanguard Asset Management, Limited, which is authorised and regulated in the UK by the Financial Conduct Authority.

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