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In current times, Central Bankers’ range of liquidity and accommodation measures in response to COVID-19 have undoubtedly been enormous, most notably, a number of policy makers have chosen to cut their policy rates to even lower levels (including the U.S., Canada, U.K. and Norway). And, of course in Australia, policy rates have fallen to 0.25%. With the RBA’s target cash rate reaching historical lows, many multi-asset investors are questioning the role of high grade bonds in portfolios – that is, how much more can yields fall and can they still be relied on as a defender against risk assets?
Australian high grade bonds have proven to be effective diversifiers for balanced portfolios, especially during stressed market environments. A look at the history of Australian shares and their drawdown episodes since 1976 shows there have been twenty-two (22) such cases, since 1976. With five (5) material equity market drawdowns in each decade, the cushioning effect of high grade sovereign bonds (represented by the Bloomberg AusBond Treasury Bond index) is evident throughout this time.
Maximum Australian share market drawdowns between and Australian Treasury Bond Market performance, 1976 to July 2020.
While it’s true that high grade sovereign bond returns aren’t spectacular relative to growth assets, their role as a diversifier and counterweight to major falls in the Australian share market is. In all of the 22 share market drawdowns, Australian Commonwealth Government Bonds outperformed their risky exposure counterparts and offered a valuable shock absorber. On one occasion in 1994, the defensive exposure recorded its softest return – even so, the exposure still outperformed the share market. In financial market terms, this event was extraordinary, marked by a rapid rise in rates by the RBA of +2.75% within a brief six-month period − as the RBA followed the U.S. Federal Reserve’s lead in an effort to tame inflation once and for all.
In contrast to modern times, the past decade’s inflationary pressures have been modest even in a low-interest rate environment. The reality is that the world, and in particular the U.S., is currently more concerned about deflationary pressures.
Looking at this historical view where interest rates were much higher than today and inflationary pressures were mounting, high grade bonds have been an effective diversifier. However, in evaluating how the asset class has performed in conditions more similar to our current environment (i.e. low prevailing interest rates), can they still be relied upon today?
Low (and even negative) rate environments have been employed by central banks across a range of developed market countries, including most notably Japan, Germany, Denmark Sweden and Switzerland (see chart 2). A look at a range of real-life and tangible episodes from around the world to assess the low rate policy effects on the ability of high grade sovereign bonds to defend and protect portfolios against equity risk.
Selection of developed markets that have employed zero to negative interest rate policies.
Consistent with the earlier analysis, chart 3 shows the maximum drawdown events for each nation’s local shares (i.e. less than -5%) versus the performance of the local treasury index (i.e. high grade sovereign bonds).
Maximum share market drawdowns, alongside treasury bond market performance.
The share market declines (or left-tail events) illustrated above have been fairly frequent, and, as with financial market stress, other risk asset classes also suffered losses – including international shares and listed property, which can provide limited diversification during periods of extreme volatility as there is correlation between risk assets.
With more than 25 years of Japanese policy rates at 0.50% or lower, and low to negative rates since 2012 across key developed markets such as Switzerland, Germany, Sweden and Denmark, local treasury bond markets have provided solid accretive returns coupled with continued muted volatility. Low yield levels alone aren’t necessarily a reason for investors to ignore high grade bonds.
Some investors believe that a bond benchmark with a longer duration should be avoided. The reality is that a longer benchmark duration does not necessarily lead to greater risk. A +1% increase in yields will result in a higher capital loss relative to a lower duration (as it was during much of the 1990s) – this is mathematically true. But there is more to bond risk than just this single metric. To understand this, consider both the duration level (i.e. the weighted average time to receive all cashflows – coupons and principal), and the chance of a shift in yields.
With potential signs of an overheating global economy around 1994, the probability of yields increasing over a 12 month period were much greater than they are today. Policy makers were concerned with managing rising inflation and the potential for economic overheating. Today’s policy makers are busily trying to raise and maintain a reasonable inflation trajectory via significant stimulus and policy accommodation. The world is in a far different place to the mid-1990s.
Asset class behaviours since the Global Financial Crisis (GFC) have long conditioned investors to expect more of the same (that is, elevated returns partnered with dampened risks, linked to central bank/government moral hazards) – see chart 4.
February and March 2020 reminded investors of the need to appropriately assess risks, changing economic conditions and the potential for real market drawdowns. Investors re-learned when markets turn, they turn quickly. Against this backdrop, it is no surprise that investors now lean toward defensive exposures and look to position portfolios for a sober forward-return environment.
Rolling 3 year p.a. returns of Australian and International shares, Australian and International REITs.
For a variety of reasons, bond yields have declined across the globe, providing investors with much lower coupon rates. This implies that compared to higher yielding environments, cash flows from fixed income are more dominated by the capital return at maturity. Even with duration levels rising, and yields falling, high grade sovereign bonds still retain their defensive properties.
As illustrated, high grade sovereign bonds have broadly moved in the opposite direction to shares – even at very low yields – displaying low-to negative-correlation to risk assets.
High grade bonds as a classic defensive exposure are income-producing assets, meaning that unlike shares (which primarily rely on capital appreciation to drive returns), they derive the majority of their returns from income, and the income on their income. Far less defensive assets such as corporate credit, illiquid or speculative exposures are often allocated to portfolios for defence, income and liquidity, but often fall short of these qualities.
A global bond allocation can provide the additional country/regional, currency and security diversification, alongside with currency yield pick-up. Global sovereign bonds receive their returns from coupons (income), changes in bond values from term structure shifts and, often neglected, the currency hedge yield pickup (in effect, the forward premium from the difference between Australian and offshore cash rates in the currency that is hedged).
Correlation measures between shares (domestic being the Australian Treasury Bond Index and offshore, the G7 Treasury Bond Index as shown in charts 5 and 6) highlight the benefits of this defensive asset class. Rolling correlations remain relatively low (or even negative) over extended periods. Even with low interest rates, these metrics have not spiked, contrary to some market beliefs. Simply put, if high grade bonds were to lose their protective properties, correlations would also dramatically increase in poor share market periods, and approach 1.0. This however is not the case in Australia, or globally in the markets we have identified as having low to negative rates.
The countries with low interest rate policies show the same type of rolling correlation outcomes between their respective local share markets and local treasury markets. In some instances (such as Denmark), persistent negative correlations have become marginally positive in recent times – but very weak. This means that the diversifying properties of high grade sovereign bonds have largely remained intact.
By the end of 2019, the world was already showing signs typical of a late-cycle phase. Material structural imbalances were unfolding including spluttering regional and global demand, over-indebtedness in major pockets, and weak inflationary impulses. The onset of COVID-19 has dramatically devastated the world, and central banks and governments have quickly implemented enormous emergency liquidity and accommodation measures to prevent the world from descending into deep recession and potential depression.
Meanwhile, three key megatrends have conspired to temper worldwide growth and inflation.
1. Aging demographics – the older generation increasing in proportion to many countries’ populations, meaning rising public financing obligations, and changing workforce dynamics.
2. Technology innovation (resultant increasing industrial efficiency, decreased production costs) and the altering of the human/physical capital balance – producing headwinds for global spending levels, economic growth and inflation.
3. Massive (and ever growing) debt burdens, which traditionally lower additional credit creation, spending and investment – incentivising central banks to keep rates lower for longer.
To be sure, inflation could become an issue down the track. The enormous fiscal and monetary easing alongside with re-emerging supply chains and disillusionment with globalisation in favour of local independence could all provide the impetus for rising prices. One possible scenario sees a global economic recovery brought about by vaccine development and widespread distribution, lockdown removals and the effects of stimulus combining to resemble the periods following World War II. Such an optimistic scenario differs markedly from where the world is currently. We have witnessed the sharpest fall in U.S. growth expectations and the fastest collapse in the U.S. labour market of all time. Treasury yield curves in Australia and the U.S. at the time of writing remain decidedly flat, with the market concerned about a prolonged global recession (or even depression) from the fallout of the COVID-19 shock. The pathway to recovery from here may be potentially longer than broadly expected.
There can be no argument – bond yields are indeed at historically low levels, an indication of the emergency settings in place to keep the world from descending into a bleaker alternative.
Based on our assessment, in both rising and falling interest rate environments, high grade bonds can play a critical role in portfolios. Even more so in the current environment of poor global growth, low inflation and falling yields, which look set to remain.