With sovereign bond yields back down to record lows, it again casts the spotlight on how to invest for a defensive client. Should advisers be allocating a large proportion of assets into gilts and cash while locking clients into negative real yields in the process? What should be classified as a defensive asset in this low yield world? This is a question we at Morningstar’s investment management group have been wrestling with for some time.
As a result of the low yields on offer, we’ve been running an underweight fixed income stance throughout 2015 and 2016, raising cash levels and favouring alternatives within our discretionary portfolios. However, we’ve stopped short of selling all government bonds and we continue to recommend investing a portion of client assets in fixed income funds.
Indeed, for our lower risk clients, bonds still make up the bulk of our recommended allocation. For some asset allocators outside Morningstar though, the answer has been to aggressively move their portfolios out of fixed income markets and into alternatives.
Diversification
As a general rule, long-term government bonds are negatively correlated to large-cap stocks. There will be periods when the two asset classes move together, such as in the taper tantrum of 2013, but over the long term, they will tend to move in opposite directions.
This is an extremely powerful tool for asset allocators. Combining asset classes with negative correlations can provide investors with superior risk-adjusted returns and help dampen the volatility of the overall portfolio.
Even with bond yields at their current low levels, the propensity for bonds to move in opposite directions to equities continues to be demonstrated. Difficult quarters, such as the third quarter of 2015 and the first three months of this year, saw equity markets fall and government bond markets appreciate.
Defensive Assets – A History Lesson
As part of our asset allocation work, we compared the MSCI United Kingdom as a proxy for UK equities with four asset classes typically described as having defensive qualities – UK gilts, global government bonds hedged to sterling, global government bonds unhedged and short-term gilts.
We focused on the worst peak-to-trough drawdowns of the MSCI UK since 1975 and the defensive qualities of the four asset classes are clear when you focus in on the biggest drawdowns that ended in 2003 and 2009. There were some drawdown periods where the asset classes merely protected rather than appreciated, but only in one period in 1994 did all four lose money.
We also looked at the price return of gilts in these periods as the carry benefit will clearly be lower today than historically. Excluding income and the contribution of gilts in the drawdown periods is rarely significant – offering capital protection rather than offsetting other losses.
Other fixed income asset classes, like investment grade credit, almost always underperform government bonds in periods of drawdown and do a poor job of protecting clients’ capital.
US Dollar
It is a common belief among investors that the US dollar is a safe haven currency and can help protect capital in times of stress. This was most clearly seen in the 2008 crisis when the US dollar delivered extremely strong returns against sterling. Global bonds unhedged returned a staggering 59% in the 2008/09 drawdown against a UK equity return of -38.4%.
However, when focusing on the 10 worst drawdowns since 1974, the dollar doesn’t fare so well, appreciating in only three of the ten periods examined. It is the Swiss Franc that fared the best, appreciating in eight of the ten drawdowns.
Fair Value?
For every asset class, Morningstar’s investment management group generates what we consider a fair value based on our long-term analysis. Our fair value for the UK 10 year gilt is between 4% and 5% - clearly a long way above today’s rate.
It seems a long time ago but the 10-year gilt yield was sitting at 3.49% as recently as December 2013. A return to these levels from a more recent yield of 1.2% in 12 months would produce a return of -20.9% for the 10 year bond; if it took two years to return to this level, the return would be -9.4% in year one and -8.4% in year two. Clearly these types of return would make a defensive client very uneasy indeed.
However, it would be remiss to discount the UK moving to a German yield scenario. In this scenario, unlikely but not completely unrealistic, the return in the first year would be 13% plus.
In our Morningstar Managed Portfolios, our government bond level is at record lows – and we have been moving assets into cash at the asset allocation level. In 2010, for example, we advised conservative clients to invest 25% in gilts and 15% in cash. This year we’ve reduced the gilt weight to 14% and increased cash to 20%.
Our view is that even with yields at record lows, it is difficult to ignore history and the humble government bond remains one of the better sources of diversification.
