The relationship between fixed income and equities is being overlooked by advisers, as they continue to use hybrids and term deposits without properly understanding the correlations.
"When you have a volatile asset class like equities on the one side, you need to have something offsetting that in your balanced portfolio - that's fixed income," BT Investment Management (BTIM) head of income and fixed interest Vimal Gor said at the company's adviser forum in Sydney yesterday.
"It's like an insurance policy - you pay a little bit every year but when you get big market moves, like your house burning down, it pays out."
Gor clarified how fixed income will work in a diversified portfolio, compared to term deposits and hybrids.
"You own fixed income for the negative correlation to equities, not because you want to preserve capital," he said.
"What we're hearing is that people have sold out their fixed income because they think it's in a bubble and what they're doing is making an equity and term deposit portfolio.
"The problem with that is TDs are not negatively correlated to equities in times of stress [so] hunkering down in cash is not a good idea."
In addition, the ANZ hybrid behaved like equities during the global financial crisis, falling 15 per cent whereas ANZ bonds rallied 10 per cent when equities fell, he said.
"The reason you get a high yield with hybrids is because they're negatively correlated, which means they perform like bonds in good times but perform like equities in the bad times, which is exactly the opposite of what you would like."
Furthermore, advisers forget that while inflation is the enemy of bonds, it's also the enemy of equities.
"In a high-inflation environment, bonds will have a negative real return but in a deflation environment, bonds perform incredibly well," Gor said.
"I'm hearing that a lot of people are worried about that inflationary environment coming in the next couple of years so they're selling their bonds and buying equities to hedge that exposure.
"If you put equities on, funnily enough, they do really badly in times of high inflation so equities have a sweet spot between minus-5 and plus-10 inflation, but as soon as you get to hyperinflation or in times of deflation they do really badly."
Advisers should essentially be asking themselves three key questions, Gor said.
"Do I have enough of an allocation to fixed interest in my client's portfolio, have I selected my fixed-interest beta appropriately and does my fixed-interest manager employ the right active strategies for this environment?"
"In a world which is losing its safe haven, you want to buy the best bonds you can to get the highest yield and funnily enough, Australia offers that."
