- Global bond yields have fallen to record lows at the same time as most developed equity markets have hit new highs. Investors are worried that bonds have lost their diversifying qualities.
- In this paper we provide the historical context and discuss what drives the equity bond correlation. We conclude that, under Western Asset’s investment outlook, bonds retain their place as one of the best and most reliable hedges to equity market risk.
- We also discuss alternative hedging strategies away from traditional bond beta and conclude investors should seek a multitude of diversification strategies to reach their investment goals.
Introduction and Background
In 2012 Gordon Stanger, a researcher from the Solomon Islands, went to the trouble of counting how many times Ian Fleming’s fictitious British Spy, James Bond, had been shot at. The number was 4662 times. He went one step further, ascribing a 5% probability of Bond receiving a fatal wound on each occasion and calculated the probability of Bond being alive today was approximately 1.4x10-104 or, in Stanger’s words, “as close to zero as makes no difference.” Despite the odds stacked heavily against Bond, he continues to live to die another day. There are remarkable similarities between James Bond and bond markets today with global bond yields at record lows. For some time now, the odds have been stacked against bonds providing the diversification investors require during times of equity weakness. Like James Bond, however, bonds continue to fight on, providing much needed ballast during periods of equity market weakness. In this paper, we challenge a growing perception that bonds no longer offer adequate diversification, provide a perspective on alternative hedging strategies and discuss Western Asset’s approach to reducing volatility across its Global Total Return (GTR) strategy.
Western Asset’s philosophy is that markets often misprice securities and that consistently investing in undervalued securities can deliver attractive returns over time for our clients. It makes sense that buying stocks priced below the underlying worth of a company or bonds priced at a significant discount to par should yield positive returns over a long enough time horizon. Warren Buffet once remarked “investing is simple but not easy.” The “simple” part is identifying the stock or bond priced at discount to fundamental value, but the part that is “not easy” is calculating the fundamental fair value and taking a position. We think investing in global fixed-income can no longer be described as simple. Astonishingly, 97.5% of all bonds in the Citigroup World Government Bond Index are currently priced above par,1 highlighting the difficulty fixed-income investors currently face. The opportunities to identify value in global sovereign bonds are becoming increasingly few and far between.
Extraordinarily easy global central bank policies implemented in the aftermath of the global financial crisis have inflated global equity valuations and pushed global bond yields to historic lows. In short, the assets that savers own to generate capital growth and income (equity) look expensive but the assets that savers often own to provide a hedge (bonds) also look expensive (see Exhibit 1).
With traditional assets appearing overvalued (and by extension benchmarked strategies looking less appealing), the search for returns has understandably led to an increase in allocations to alternative assets and strategies, funded from both growth and defensive allocations. Though these asset classes vary in form and function, their inclusion generally increases the risk attributes of the broader portfolio.
Investors are seeking alternative ways to mitigate equity volatility and manage drawdown risk away from traditional sources of diversification like bonds. These include so called tail-risk protection strategies that extensively use derivative contracts and currency strategies that rely heavily on historical correlations being maintained, as well as consistent investment manager skill in identifying opportunities.
Derivative Strategies: Equity Puts
Equity puts are, without a doubt, an excellent hedge to equity risk. Short-dated options, however, which are highly desirable due to their very high sensitivity to changes in price (gamma), are expensive to hold as they suffer from significant time decay. Like a car insurance policy that pays out in the unlikely event of a collision, the majority of the time the owner of the insurance policy is just paying premiums away each month. We demonstrate this in Exhibit 2. The red line shows the return series of a strategy in which $100 is invested monthly in a fixed number of at-the-money (ATM) S&P 500 puts, with the blue line showing the S&P 500 total return index. On the few occasions when the S&P 500 suffered drawdowns, the insurance policy (ATM puts) produced a positive return evidenced by the small upward spikes in the red line. Over time, however, the cost of insurance for these infrequent drawdowns more than outweighed the benefits. After five years, the $100 investment was worth less than $40!
Such a strategy suggests that an unsophisticated approach to hedging equity drawdowns using options is not an efficient use of investor capital. A more sophisticated approach that uses algorithms to exploit dislocations in volatility skew may suit investors’ needs more appropriately. Seeking an actively managed tail-risk hedging strategy that can partially offset the cost of insurance by earning back part or all of the annual premium can successfully protect investors’ assets from the negative volatility that causes large, unforeseen losses.
The Historical Case for Bonds
It is well known that including a bond allocation to an equity portfolio has greatly improved the portfolio risk and reward characteristics over the last 30 years. Exhibit 3 shows US equity and bond2 returns between 1985 and 2015 and how the total return/risk ratio varies as the allocation to bonds is increased.
An investment split of 40% in equities and 60% in bonds has produced a higher return than equities alone with approximately half the volatility. The correlation3 of bonds with equities has been negative over this time period; combining two negatively correlated assets together in a portfolio should reduce total volatility because the movement of one asset can be expected to mitigate some of the movements of the other. The correlation has not always been negative, however. Exhibit 4 shows the relationship over a 100-year history using US bonds and stocks, and highlights periods when the correlation has been very positive.
Accurately predicting how this correlation will behave going forward will be crucial for equity investors using bonds for diversification. Studies have found inflation to be an important variable that drives the equity-bond correlation.4 Periods of high inflation tend to coincide with positive return correlations. Intuitively this makes sense because high inflation erodes the real value of future bond coupons, and pushes bond prices down and yields up. Equities perform well during periods of moderate inflation but struggle when inflation is high as companies find it hard to pass through costs to consumers, negatively impacting profitability and dividend payments. Equally important is the level of yields. High inflation pushes up yields, making it more costly for companies to borrow and negatively impacting the net-present-value of future dividend payments. Clearly there are a number of secular and business-cycle factors that will influence the correlation going forward, but unless inflation rises substantially over the medium term, we believe it is unlikely that the long-term correlation will become meaningfully positive.
How Is the Equity-Bond Correlation Likely to Behave Going Forward?
Western Asset believes aging populations, large debt overhangs and muted global real GDP growth will keep global inflation low for the foreseeable future. We think US bond yields are unlikely to rise above what is currently priced into the forward markets and will produce low but positive returns. Global monetary policies are likely to stay accommodative and to continue to support a slow but stable global recovery. This should be an environment that is typically supportive of positive equity and corporate bond returns. Given our expectation for positive risk asset performance and low but positive expectations for bond returns, it is plausible to assume the correlation over the medium term will be low but positive. This does not mean that bonds have lost their diversification benefits.
The Equity-Bond Correlation and Drawdowns
The global recovery has faced a number of setbacks since the Global Financial Crisis (GFC). Recent periods of lower equity valuations have coincided with fears over a sharp slowdown in China, bouts of severe weakness in oil and other commodity prices, fears about the weakening of peripheral European bank balance sheets and the decision by the UK electorate to leave the EU, to name a few. These shocks highlight the fragility of the recovery and investors should expect intermittent periods of flight-to-quality over the medium term.
It is precisely during such a time when bonds can really work for equity investors, because the equity-bond correlation consistently moves decisively more negative during periods of flight-to-quality.5
We have examined the returns of US equities and bonds over the last 35 years. Exhibit 5 shows that US Treasuries (USTs) produced positive returns in eight of the 10 largest drawdown periods. We expect this relationship to hold if equity markets were to suffer another setback. The 30-year US yield is currently 2.2%, low when compared with the 30-year average of 5.8%, but high when compared with 30-year German yields of 0.4% or Japanese yields of 0.3%.6 We think 30-year US yields could fall another 50 basis points (bps) or 100 bps in the event of a large equity drawdown. The current 30-year UST bond has a duration of 22 years, so a fall of 100 bps in yields would produce a return of 22%, still capable of fully offsetting potential losses from a substantial bear market in equities.
The analysis in Exhibit 5 highlights two equity drawdown periods when bonds produced negative returns. Both coincided with periods of Federal Reserve (Fed) policy tightening. This suggests that owning US duration when the Fed is tightening rather than easing its monetary policy stance is less likely to provide adequate diversification in times of equity market stress. In a recent paper, “The Fed Waits on Rates,” Western Asset Portfolio Manager John Bellows outlined the Fed’s recent retreat from its hawkish rhetoric in May. With ongoing doubts about the Fed’s growth and inflation outlook, Western Asset believes the Fed’s stance remains focussed on risk management and that policy rates will remain on hold unless and until there is a material change in this outlook. We expect additional monetary easing measures from the European Central Bank, Bank of England and the Bank of Japan.
We therefore believe US bonds continue to provide diversification against equity exposure despite very low levels of bond yields. Western Asset’s global portfolios remain overweight US duration to provide ballast and diversification against spread sectors.
Yield Curve Strategies
Where investors hold duration along the yield curve has consequences for portfolio diversification. Typically when bond yields fall due to a global growth shock or other exogenous factors the yield curve bull steepens.7 This is because markets price in potential central bank rate cuts, which impact the short ends more than the long ends of yield curves. Today, most developed central bank policy rates are close to zero and whilst central banks are not constrained by the zero bound (as evidenced in Europe and Japan), the scope for additional rate cuts is limited. This dynamic means investors tend to focus purchases further out along the yield curve when buying duration. Exhibit 6 plots the monthly change in the shape of the UST 5/30s yield curve slope,8 against the monthly change in the UST 10-year yield, controlled for monthly falls in yields greater than -0.2%. In periods when the fed funds rate is below 1%, the curve tends to bull-flatten and for periods when the fed funds rate is above 1%, the curve bull-steepens.
Investors can use this to their advantage. One such strategy would be to implement a yield curve flattening position, which we believe has attractive asymmetric characteristics when used as a diversifier to equity risk. The above analysis suggests the yield curve is likely to bull-flatten9 during periods of equity market weakness. In the event equity markets perform well and markets price in the possibility of a less accommodative Fed we would expect the yield curve to bear-flatten10 as it has done during previous Fed interest rate hiking cycles.
Investors should be equally thoughtful about where they own bonds. In Japan and Germany, 10-year bond yields are negative, implying hold-to-maturity investors are willing to accept a nominal capital loss to hold these assets. Diversification benefits become impaired as bond yields approach zero because the deposit rate acts as a floor.
We demonstrate this by using a current example of the change in 10-year yields across five major bond markets over the week following the UK’s vote to leave the EU (see Exhibit 7).
The two worst performing bond markets were Japan and Germany (where yields were negative out to 10-year maturities) and the two best performing bond markets were the UK and US (where 10-year yields were still positive). Going forward, holders of German or Japanese government bonds are unlikely to gain diversification benefits during equity market drawdowns. With US and Australian yields well above European and Japanese levels, however, we currently believe US and Australian bond markets are still attractive diversifiers (Exhibit 8).
The Importance of an Active Approach
Some investors are concerned that bonds no longer provide adequate diversification to equity allocations. Western Asset believes bonds are still an attractive diversifier, especially during periods of flight-to-quality. One conclusion we could draw from this analysis is that there are a number of alternative ways to manage equity and spread product volatility away from traditional long duration strategies. We haven’t ranked the alternatives in any particular order because the efficacy of each strategy will depend on a number of factors such as the stage in the economic cycle, the catalyst for the equity drawdown and the cost of implementing each strategy. For example, if an investor is fearful of an imminent Fed hiking cycle, they should avoid duration strategies but might want to consider curve-flattening strategies or diversifying duration into markets where the interest cycle is stable or easing.
To mitigate negative returns in the event yields do eventually rise, investors need to take an active approach and utilise a number of the diversification strategies discussed here. Western Asset’s GTR strategy provides a solution to this problem. GTR takes its risk market exposure via investment-grade corporate and emerging market bonds. Whilst the volatility of these sectors is considerably lower than that of equity markets, the need for adequate diversification is equally important. The strategy utilises the majority of the hedging strategies discussed above to smooth portfolio volatility over a market cycle.11 Over its 10-year track record, GTR has returned 5.49% per annum with a Sharpe Ratio of 1.0. A number of the diversification strategies discussed above have been implemented in order to achieve this Sharpe Ratio. To demonstrate this, we have shown the portfolio return attribution across the 10 calendar years since the portfolio’s inception (Exhibit 9).
In years when a certain part of the portfolio was producing negative total returns, the portfolio had sufficient diversification in other strategies to either minimize, or in most cases, fully offset the drawdown. Examples of some of the strategies implanted are highlighted in Exhibit 10.
Derivative strategies aimed at protecting investors from negative market events, such as buying equity puts, can offer a more precise hedge to equity risk, but adopting an unsophisticated approach to buying insurance produces large negative total returns over time.
Historical evidence shows adding a bond allocation to an equity portfolio greatly reduces volatility without sacrificing returns.
Western Asset believes the global economy will continue to produce slow but unspectacular growth. Inflation is likely to remain benign. Bonds should produce low but positive returns over the medium term and the equity-bond correlation is likely to be low but positive. Western Asset believes the correlation will still move meaningfully negative during periods of flight-to-quality. Bonds remain one of the best diversifiers of equity risk.
Our analysis shows bond allocations provide less diversification during Fed tightening cycles. Correctly identifying the fundamental economic landscape will be crucial in determining future bond returns. Western Asset’s view is that the Fed remains on hold unless and until there is a material improvement in the growth and inflation outlook and the Fed’s dovish stance should continue to support bond valuations.
Investors need to be thoughtful about which country they own and where duration is held along the yield curve. Currently Western Asset advocates holding US duration as ballast against equity risk premium and prefers allocations to longer-dated USTs.
Adopting a more flexible approach utilizing duration, yield curve, country and currency strategies as part of an actively managed total return approach can greatly increase the chances of providing income as well as ballast against equity market weakness.
Western Asset’s GTR strategy has a proven track record in delivering strong risk-adjusted returns over 10 years and could be a good fit for investors looking for the diversification benefits of bonds but who are worried about current valuations.
- As of 12 Aug 16.
- For bond returns, we used the Merrill Lynch US Government 10+ Index.
- Correlation is the tendency of the returns of an asset to move in the same direction as another asset.
- See Reserve Bank of Australia paper "A Century of Stock-Bond Correlations" Ewan Rankin and Muhummed Shah Idil (2014).
- Gulko (2002).
- As of 15 August 2016.
- When a curve bull steepens, yields on short-dated bonds fall by more than longer-dated bonds.
- The difference between 30-year yields and 5-year yields.
- When a curve bull-flattens, yields on long-dated bonds fall by more than shorter-dated bonds.
- When a curve bear-flattens, yields on short-dated bonds rise by more than longer-dated bonds.
- The GTR strategy cannot use equity derivatives.