Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 571

Why allocating more to fixed income now makes sense

The correlation between bonds and equities is very high and not likely to correct anytime soon. So what is the solution? More fixed income. A higher correlation means that overall portfolio risk has gone up, and the total risk can be managed down through a higher allocation to fixed income. Fixed income may not play out as a portfolio diversifier, but it will continue to serve its function as a volatility diversifier. The other good news is that due to elevated yields, fixed income remains attractive on a risk-adjusted basis.

Another way to risk-manage the high correlation environment is to broaden the investible opportunity set to include global markets. Establishing exposures to different currencies, markets and geographies can help diversify portfolios. This global approach is best implemented when relying on an active asset manager that can leverage potential sources of alpha.

For now, fixed income is no longer a portfolio diversifier 

By historical standards, the bond-equity correlation is now very high. Based on a two-year window, the correlation stands at 0.71, the highest level since 1995 (Exhibit 1). A high bond-equity correlation means that the diversification benefits of fixed income have weakened. It also implies that total portfolio risk increases along with that correlation, making risk management an even more essential pillar of the investment process in a high-correlation world.

The bond-equity correlation is set to remain elevated in the period ahead

The sharp rise in the bond-equity correlation started in late 2021 when it became clear that a US Federal Reserve tightening cycle was imminent. The correlation corrected higher brutally, with the intensity of the Fed’s rate hikes surprising global investors.

While the Fed hiking cycle may well be over, the bond-equity correlation will not necessarily adjust lower. We believe, based on our macro regime framework, that the transition under way is likely to contribute to a persistently high correlation.

The prevailing macro regime during the central bank hiking phase of 2022 and 2023 was the so-called the fear of the Fed (Exhibit 2). Under that regime, rates corrected higher, while credit spreads widened. Broader risky assets came under pressure, which tended to promote a high bond-equity correlation. In 2022, both bonds and equities suffered losses.

Looking ahead, we believe the prevailing regime will likely shift to a QE-style, or Goldilocks, regime, the opposite of the 2022 and 2023 pattern. Under a Goldilocks regime, rates move lower while credit spreads tighten. Risky assets also tend to perform strongly, boosted by a central bank liquidity impulse, which means that the bond-equity correlation remains elevated. This is what we have observed over the past few months, reflecting the anticipation that the Fed is going to begin its easing cycle soon. Given that the Fed cuts have yet to be delivered, the Goldilocks regime is likely to stay in place for the foreseeable future. We believe that the bond-equity correlation will normalize lower, but not until the easing cycle is close to completion, taking us to late 2025. Once the easing cycle has run its course, the macro regime will likely shift again, this time to either the growth momentum regime or perhaps to the fear of the Fed regime.

The need for portfolio de-risking

Paradoxically, the higher the bond-equity correlation, the higher the need for portfolio de-risking and therefore the higher the fixed income allocation should be, given fixed income’s historical status as a de-risking asset class. In other words, fixed income may not play out as a portfolio diversifier but may nonetheless continue to serve as a volatility diversifier. Using the 1990s as an illustration, amid a persistently elevated correlation during that decade, we can observe that a higher allocation to fixed income led to both lower portfolio volatility and better risk-adjusted returns over that period (Exhibits 3 and 4).

Fixed income is attractive on a risk-adjusted basis

The macro environment has become more supportive of fixed income, reflecting the easing biases of major central banks, the likelihood of a soft landing scenario, and the continuing disinflation process in many countries. Current yields are well above long-term returns for many of the global fixed income sub-asset classes, which means that fixed income may be well positioned to potentially deliver robust returns in the period ahead. For the strategic investor with a longer time horizon, what really matters is total yield valuation, and that is still favorable. Historically, there has been a strong relationship between starting yields and subsequent returns. Looking at the global aggregate index, which currently yields 3.82%, we can see that in the past, a similar entry yield level was associated with a subsequent five-year median annualized return of 6.44% (with a return range of 3.66%/7.68%, Exhibit 5).

Going global as a correlation management strategy

Investors with a strong home bias may benefit from broadening the investible opportunity set to global markets. While this does not directly address the high bond-equity correlation challenges, it may help boost a portfolio’s diversification profile through the introduction of multiple region, country and currency exposures. We have observed that exposure to global bonds on a FX-hedged basis can lead to both yield enhancement and lower portfolio volatility, especially if the home market is characterized by higher interest rates as it is in the United States and the United Kingdom (Exhibit 6).

The case for global, active management 

In our opinion, the global fixed income opportunity set is best leveraged when relying on an active manager that can potentially tap multiple sources of alpha, ranging from currency management to duration positioning to hedging strategies to asset and sector allocation and global security selection. The historical alpha is comfortably into positive territory, averaging 83 basis points (gross of fees) over the past 20 years, illustrating that an active approach to portfolio management in global fixed income potentially adds value (Exhibit 7).

Overall, we believe that the high bond-equity correlation, which is currently an important feature of global markets, does not argue against allocating more to fixed income. In fact, the way to try to manage the higher portfolio risk potentially involves a higher fixed income allocation.

 

Benoit Anne is Managing Director, Investment Solutions Group at MFS Investment Management. This article is for general informational purposes only and should not be considered investment advice or a recommendation to invest in any security or to adopt any investment strategy. It has been prepared without taking into account any personal objectives, financial situation or needs of any specific person. Comments, opinions and analysis are rendered as of the date given and may change without notice due to market conditions and other factors. This article is issued in Australia by MFS International Australia Pty Ltd (ABN 68 607 579 537, AFSL 485343), a sponsor of Firstlinks.

For more articles and papers from MFS, please click here.

Unless otherwise indicated, logos and product and service names are trademarks of MFS® and its affiliates and may be registered in certain countries.

 

2 Comments
SMSF Trustee
August 02, 2024

I think these arguments confuse duration strategy with asset allocation strategy. All the arguments, if you believe them, point to setting your fixed income portfolio with more long term bonds. That doesn't mean changing your asset allocation which should be based on longer term considerations not where we are in the cycle.

The problem is, as I write this today, bond yields have fallen in the last week by quite a bit. 10 year Australian government securities are now paying just over 4%. That's not compelling to me and I shortened duration in my fund today. I had added long bonds at 5% and again a few weeks ago at 4.5% when the case was much stronger than it is now when the market has jumped the gun on rate cut expectations.
In all this I haven't touched my equity allocation which has been doing quite nicely thank you.

Errol
August 01, 2024

At what cost? My super fund has a balanced risk adjusted fund that has only met its performance objective once in the last 5 years and in the last 2 years has underperformed the better balanced funds by ~50%. Given that this is an actively managed fund with higher fees, the performance of such a fund would seem to rest on the skills of the investment team to leverage “alpha”. This is not an easy ask for a large super fund with high FUM.

Loading up on bonds over the last few years has been a significant detractor from performance. While volatility may prove to be lower, the cost of such a strategy in underperformance is huge. I’m not convinced that these balanced risk adjusted funds will deliver similar levels of performance with less volatility over the long term.



 

Leave a Comment:

RELATED ARTICLES

Do private investments belong in a diversified portfolio?

Fixed income investing when rates are rising

Stars align for fixed income

banner

Most viewed in recent weeks

Vale Graham Hand

It’s with heavy hearts that we announce Firstlinks’ co-founder and former Managing Editor, Graham Hand, has died aged 66. Graham was a legendary figure in the finance industry and here are three tributes to him.

Australian stocks will crush housing over the next decade, one year on

Last year, I wrote an article suggesting returns from ASX stocks would trample those from housing over the next decade. One year later, this is an update on how that forecast is going and what's changed since.

Taxpayers betrayed by Future Fund debacle

The Future Fund's original purpose was to meet the unfunded liabilities of Commonwealth defined benefit schemes. These liabilities have ballooned to an estimated $290 billion and taxpayers continue to be treated like fools.

Australia’s shameful super gap

ASFA provides a key guide for how much you will need to live on in retirement. Unfortunately it has many deficiencies, and the averages don't tell the full story of the growing gender superannuation gap.

Looking beyond banks for dividend income

The Big Four banks have had an extraordinary run and it’s left income investors with a conundrum: to stick with them even though they now offer relatively low dividend yields and limited growth prospects or to look elsewhere.

AFIC on its record discount, passive investing and pricey stocks

A triple headwind has seen Australia's biggest LIC swing to a 10% discount and scuppered its relative performance. Management was bullish in an interview with Firstlinks, but is the discount ever likely to close?

Latest Updates

Investment strategies

9 lessons from 2024

Key lessons include expensive stocks can always get more expensive, Bitcoin is our tulip mania, follow the smart money, the young are coming with pitchforks on housing, and the importance of staying invested.

Investment strategies

Time to announce the X-factor for 2024

What is the X-factor - the largely unexpected influence that wasn’t thought about when the year began but came from left field to have powerful effects on investment returns - for 2024? It's time to select the winner.

Shares

Australian shares struggle as 2020s reach halfway point

It’s halfway through the 2020s decade and time to get a scorecheck on the Australian stock market. The picture isn't pretty as Aussie shares are having a below-average decade so far, though history shows that all is not lost.

Shares

Is FOMO overruling investment basics?

Four years ago, we introduced our 'bubbles' chart to show how the market had become concentrated in one type of stock and one view of the future. This looks at what, if anything, has changed, and what it means for investors.

Shares

Is Medibank Private a bargain?

Regulatory tensions have weighed on Medibank's share price though it's unlikely that the government will step in and prop up private hospitals. This creates an opportunity to invest in Australia’s largest health insurer.

Shares

Negative correlations, positive allocations

A nascent theme today is that the inverse correlation between bonds and stocks has returned as inflation and economic growth moderate. This broadens the potential for risk-adjusted returns in multi-asset portfolios.

Retirement

The secret to a good retirement

An Australian anthropologist studying Japanese seniors has come to a counter-intuitive conclusion to what makes for a great retirement: she suggests the seeds may be found in how we approach our working years.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.