Many with superannuation or personal investments may be familiar with their investments being classified into two categories: “Growth” and “Defensive”. While the COVID-19 lockdown induced recession has had a well-publicised negative effect on growth assets initially, these growth assets include shares and property, less frequently discussed is the effect Covid has had on defensive assets.
Typically defensive assets, such as bonds, are associated with less volatility, the conventional belief is that bonds move oppositely to shares, (e.g. rise when shares fall). While these assumptions may have held true in the past, the current low-interest-rate environment has muddied the waters.
With central bank overnight rates at record lows and even negative in many parts of the world, the yield or interest rate on government and corporate bonds has been pushed to all-time lows. This has had a damaging effect on future returns for bond investors who derive interest payments on bonds.
For high-quality government bonds, the yields are now typically below 1%. Sure many bonds have risen in value, but if they do not continue to rise in value in response to rate cuts, defensive investors are looking at very slim income returns.
Investors are faced with two options - accept the ultra-low rates of highly rated bonds or accept more risk. This is the unenviable position superannuation funds and fund managers face when investing a portfolio “defensively”. Managers frequently have a mandate to invest a certain percentage in fixed interest investments, such as bonds. With quality government and corporate bonds paying unpalatably low-interest rates, many have invested in riskier higher interest corporate bonds.
Bonds are bonds, right? This is where many of the assumptions around how bonds and shares are correlated (bonds tend to rise when shares fall, and vice versa) may have or will change.
The yield on government bonds is too low to provide protection against inflation, and corporate bonds are still impacted by the fundamentals and the solvency of the issuer, much like is the case with shares (bad news for a company will often hurt the equity and bonds issued by a company).
This structural shift has meant that in times of share market volatility, such as the end of 2018 and most recently during the pandemic sell-off, bonds are not playing their defensive role by increasing in value as well as they have in the past. The changing relationship is highlighted in the table below.
*Global equity = MSCI World Equity Index; Global Bond = Barclays Global Aggregate Treasuries Bond Index. Returns based off-peak to trough index price change over equity drawdown period: global bond yield= index yield at the beginning of the equity drawdown period. Source: Bloomberg.
This change in the relationship between shares (equity) and corporate bonds within defensive portfolios has a flow-on effect for balanced portfolios. As an example, investors with 60% growth assets and 40% defensive assets may be faced with far more volatility than previously. This is at least partly due to the fact that riskier corporate bonds are behaving more like shares, but also as interest rates are so low, there is less income derived from bonds than in the past, so less of a buffer if capital values fall.
Bonds still play an important role in a portfolio and good bond fund managers still have ways of extracting returns from their portfolio, and actively managing some of the risks on the sector.
However, it must be understood that the risk and reward trade-off inherent in portfolio construction is changing in a world enduring incredibly low or negative interest rates.
When stressed by systemic events such as a global pandemic or a future financial crisis, a traditional portfolio's defences’ may not hold, and a more active approach to risk management may be required. Those nostalgic about the past often exclaim “things ain’t what they used to be”, we are feeling this way about defensive assets such as bonds.
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