Ultra-low interest rates/bond yields have fundamentally changed the risk vs return proposition of government bonds and also challenge conventional assumptions about the defensive role they are supposed to play.
Low bond yields mean small yield cushions, which directly reduces the defensive benefits of government bonds and also makes their forward-looking risk vs return profile unfavourably asymmetric.
While we certainly don’t advocate abandoning conventional duration-based government bond investments altogether, we do think it is now suboptimal for multi-asset portfolios to be overly reliant on duration for portfolio diversification and downside protection.
Vanishing yield cushions
Conventional government bond investing relies on accumulating portfolios of bonds to harvest yield. The flip side of yield is interest rate duration risk, which is the primary risk inherent in high-quality government bonds. Duration measures the sensitivity of bond prices to changes in interest rates/bond yields. Rising bond yields mean falling bond prices and vice versa.
Government bonds are most commonly used to play a specific defensive risk diversification role in multi-asset investment portfolios. The assumption is that when equities fall, bond yields decline, and bond prices rise. The resulting capital gains for bonds help offset equity losses. This is the central diversification assumption that conventional portfolio construction relies on.
We can think of the stable income-provided bonds, together with the additional capital gain potential from falling bond yields, as a “yield cushion” that helps offset equity losses in adverse market environments. The size of this yield cushion is then a key determinant of how well bonds play their defensive role.
High bond yields mean large yield cushions, which allow conventional bond investments to play their defensive role well. But with bond yields now fast-approaching zero, those yield cushions are vanishing.
When the starting point of bond yields is already close to zero, bonds deliver less income and become inherently less defensive because there is simply less room for bond yields to fall further and deliver the capital gains needed to cushion equity losses.
Looking back prior to the Q1 2020 virus-induced turmoil, collapsing global bond yields, turbocharged by extreme monetary policy easing, delivered large windfall capital gains to any bond portfolio with duration exposure.
Unusually, this happened over a period in which equities reached record highs. This was a dream scenario for multi-asset portfolios because the return-seeking equity side of portfolios, as well as the defensive bond side, both experienced a highly correlated rally. But that came at the cost of vanishing yield cushions.
Looking forward, the picture is very different. With yield cushions vanishing and yields now close to effective lower bounds, there’s no room left for bonds to repeat those historical windfall gains, unless you’re confident that bond yields can push deeply negative.
The unfavourable asymmetry of interest rate duration risk
Ultra-low bond yields have also left conventional duration-based government bond portfolios with a forward-looking risk vs return profile that is unfavourably asymmetric i.e. they face limited future upside potential vs the possibility of large downside risks.
Near zero yields mean very low expected returns going forward. Meanwhile, the duration risk of conventional bond indices has increased, meaning greater risk of capital losses if yields were to rise. Investors are therefore left facing more interest rate risk for less return.
This unfavourable asymmetry is inescapable when the starting point of yields is already near zero because there’s naturally less room for them to drop further. This is what makes chasing bonds at record low yields (i.e. record high prices) very different to chasing stocks at high valuations. Stocks can keep going up indefinitely. Bonds can’t.
Given the complex web of variables and feedback loops that drive bond yields, nobody can reliably predict which way bond yields will head from here. While the future direction of bond yields is uncertain, what’s clear right now is that the risk vs return profile of conventional duration-based bond investments has become unfavourably asymmetric.
Implications for portfolio construction
Conventional high-quality government bond investments are widely assumed to be “safe” investments, and in terms of credit default risk that assumption does hold. However, they are no longer “safe” in terms of the risk of near-term capital losses stemming from the unfavourable asymmetry of duration risk.
Investors rushing to the perceived safety of government bonds have careened headlong into the poorly compensated and treacherous territory of interest rate risk, perhaps forgetting the old adage that the price at which you buy matters as much as what you buy. Government bonds are not immune from losses if you buy at too high a price, and that’s doubly true when faced with such unfavourable asymmetry.
In the absence of any directional view on bond yields, duration exposure is often held solely as a defensive risk diversifier to cushion multi-asset portfolios against downside equity risks. But even in this use case, vanishing yield cushions mean duration can no longer play this role as effectively as it used to.
We have now experienced two large equity drawdown episodes (Q4 2018 and Q1 2020) where conventional duration exposure failed to provide the kind of portfolio protection that it has in the past. These should be heeded as warning signs because they are not temporary blips. They represent a paradigm shift driven by vanishing yield cushions and the unfavourable asymmetry of duration risk.
While there is still a role for conventional government bond investments, particularly because they are easy to understand and cheap to access, they are also a blunt instrument that works best when the starting point of bond yields is reasonably high.
Access to a cheap beta exposure like duration can be attractive when that beta exposure offers an attractive risk vs return proposition and can reliably play a portfolio role. Failing that it can be a false economy.
This is not to say that conventional duration-based government bond investments should be abandoned entirely. Rather, we conclude that it is now suboptimal for multi-asset portfolios to be overly reliant on duration for their defensive risk diversification.
It is now time to look beyond the conventional duration lever and consider other defensive diversifiers that can help fill the gap when duration doesn’t work as well as hoped.
Gopi Karunakaran, portfolio manager, Ardea Investment Management
