The role of bonds in a crisis
08 April 2020 | Portfolio construction
By Giulio Renzi-Ricci, senior investment strategist, Vanguard Europe.
The economic repercussions of the Covid-19 pandemic have brought sharp declines in equity markets in recent weeks, with investors looking to their bond exposures to cushion some of the blow. In March, however, the value of fixed income securities and funds fell across a wide range of durations and currencies. For example, the Vanguard Global Bond Index Fund (GBP hedged), which tracks a representative global basket of high-grade bonds, was down 1.9% in March.
Even the traditional 'safe haven' of developed market government bonds failed to provide refuge from the market turbulence in this period, with yield curves rising at certain periods to compound investor pain. The Bloomberg Barclays Global Aggregate Treasuries index (GBP hedged) was down -0.17% in March. While the Bloomberg Barclays Gilt index rose 1.52%, developed market government bonds in many regions fell, with the Bloomberg Barclays Germany and France Treasuries (GBP hedged) indices down -1.26% and -2.71%, respectively.
The simultaneous fall in both bonds and equities has raised questions about the diversification benefits of fixed income securities and their role as shock absorbers during periods of market distress.
The rationale for maintaining a balance between bonds and equities is based on the understanding that bond returns tend to move in the opposite direction to equity returns. A healthy exposure to bond markets should provide investors with a cushion to absorb some of the losses when equity markets inevitably tumble. This feature is normally enhanced for longer-duration bonds as highlighted by Figure 1.
Figure 1. Performance of government bond indices for different durations during worst quartile of equity performance
Past performance is not a reliable indicator of future results.Sources: FTSE All-World Index in GBP and Bloomberg Barclays Global Treasury (GBP Hedged) indices. Data from 31 January 1999 to 31 March 2020.
So, why were bond valuations falling at the same time as equities? And does that mean that the relationship that we have been relying on for asset allocation is dead and that bonds no longer play the role of risk diversifiers in a multi-asset portfolio?
One of the observable trends during distressed markets is the 'flight to quality', but in the case of the Covid-19 pandemic we have seen a 'flight to cash'. By that we mean investors are selling their equity and higher-risk bond (high-yield) positions, holding the cash and waiting for the volatility and uncertainty to reduce.
Similarly, asset managers facing redemptions tend to sell their most liquid assets first, which are typically developed market government bonds and high-quality corporate bonds. This has put further downward pressure on bond prices as it happened in tandem with the economic reaction to the spread of Covid-19 (e.g., layoffs, declines in growth as a result of the containment measures). Although difficult to forecast, the flight to cash is likely to be temporary, and once market confidence bounces back and investors buy back into marginally riskier assets, the correction could be sharp.
Another explanation is that the large fiscal packages that have been rolled out in the US and Europe have put upward pressure on government bond yields as markets price in the added credit risk associated with more borrowing. If the fiscal stimulus works, though, we should see a reversion in government bond yields over the next couple of months.
In fact, we should think about why equity and bond returns tend to move in opposite directions. The conditions for that to hold are related to how monetary policy responds to equity sell-offs. Over the past 20 years or more, since central banks widely adopted inflation-targeting policies, they have responded to economic growth shocks by rapidly lowering interest rates (and therefore bond yields), which ultimately pushes bond returns up. This is exactly how central banks have been responding to the Covid-19 shock.
Of course, this dynamic does work less effectively when interest rates are already low, as in the current economic environment. When yields are already very low, there is less room for them to decrease further and therefore bonds provide less downside protection compared to a high interest rate environment. But even then, they still provide some protection.
High market volatility is the result of many variables impacting the market at the same time, including irrational human behaviour. With that in mind, we can't expect the negative correlation in equity and bond prices to hold each and every day, but rather on average over the investment horizon. For now, there is no reason to abandon the long-standing position that bonds will perform their duty as shock absorbers in multi-asset portfolios.
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