The “old way” of managing multi-asset portfolios has come to an end because of how low bond yields currently are, according to Legal & General head of diversified strategies Martin Dietz.
Bond yields recently rose to above 1 per cent as investors priced in higher inflation during a strong post-Covid economic recovery, but this are still low by historical standards.
According to Dietz, bonds have typically served two purposes in portfolios.
The first to help manage the risks in portfolios by adding duration.
“The idea is very simple. If something bad happens, central bankers will cut the short end and yields fall and therefore bonds go up. And that offsets the kind of the risky assets,” Dietz said.
The second part is generating returns, which Dietz said bonds were previously good at doing.
“Bonds have done very, very well, not just because the yields are high, but because the yields were kind of structurally falling as well,” Dietz said.
But according to Dietz neither of these things are going to be major characteristics of bonds going forwards: “Now what we are saying is, none of these two are likely to be a big a big driver going forward. And that has big implications for how we structure portfolios.
“Obviously, the historic old-fashioned way of doing a multi-asset portfolio as a balanced fund benefited a lot from the bonds doing well. You could say that risk parity funds take that one or two steps further. So again, a lot of focus on being exposed to equities on one side and bond on the other side.
“So what we need to do is to structurally prepare portfolios for an environment where this is no longer possible, where we really don't want to avoid this kind of bond duration and so we need to replace the bonds as a risk mitigator and we need to replace them as a return generator.”
With that Dietz highlighted several things investors could do to prepare their portfolios for this new environment where yields are very low and bonds don't serve the same purpose in the portfolio sd they have historically.
Diversification
The first point is looking at how the role of bonds as a hedge against risk has changed.
Dietz said one thing investors needed to do was add more diversification to portfolios and not just by relying on an equity and bonds split.
“We need more diversification,” Dietz said. “And that's very similar to saying the balanced fund is dead.
“We cannot just have equities and bonds in a portfolio, we need to focus on all of the alternatives. And that might be whatever: emerging market debt, high yield, infrastructure, listed property, commodities.”
Seek out other yields
The second point is seeking out other yields. Dietz explained that developed market bonds generally have a low yield and this is not something he expects will change over the next 30 years.
Instead, investors can “selectively” seek out other higher yield options.
Dietz explained: “Number one, quite a number of emerging markets. We've the Chinese bond market in here, but you would find very similar things in a number of other kind of emerging markets.
“But even on the developed market side, something like Australia. Yes, the very front end it is at close to zero, but at least there's some ability for the long end to fall to fall further. Korea another one. Still low at the front end, but still quite normal looking across the rest of the curve.”
Deploy options
The third option is reducing overall risk or being more selective in reducing risk through the fund’s equity options.
Defensive currencies
The fourth option is using currencies defensively.
Dietz said: “We think the idea of almost automatically hedging all of your currency risk is probably not appropriate. Some currency risk does good for a portfolio and, if we talk about risk management, there's a number of defensive currencies that can serve a similar purpose to ones historically.”
There are several “really safe haven currencies”, according to Dietz, which can be used to hedge portfolio risk.
“A very classical ones here obviously the Japanese yen and the Swiss franc, but also the US dollar is a risk-off currency for euro and sterling investors,” Dietz said.
“And then all the way on the other side, we typically think of sterling as a more risky currency. So for a sterling investor it may actually make sense to keep exposure to foreign currencies in general.
“We've seen that a number of times: 2008-2009, obviously, where sterling [had] short term losses, the end of 2018 and the virus crisis last year. These are all periods where there's severe stress and sterling is one of the currencies that then sells off.”
Less inflation protection
The fifth point was around inflation and more specifically how this relates to bond yields.
Dietz said that when people say bond yields are low what they really mean is that real yields are low.
Therefore, it’s not the “depreciating inflation”, which he think is unattractive, rather it’s that the real bond yields are low and this means less inflation protection for portfolios.
He said: “It's the real yields that are low and that means less inflation protection, both through TIPS (treasury inflation-protected securities) and other inflation linked bonds, but also maybe selectively in some real assets, are not as attractive as they have been historically.”
Extend credit risk
Moving onto changing the role of bonds as ‘return generators’ in portfolios, or substituting them for other assets to generate returns, Dietz said one way to do this was through credit risk.
“Now we can try to get extra return on the credit side, extend credit risk, whether this may be rewarded illiquidity premium across a number of asset classes, including in credit,” he said.
“We think there are some bond substitutes, the kind of areas where we find relatively stable cash flows, and maybe there's some additional risk in comparison to bonds. But if we look at the infrastructure side, for example, the stability of the cash flows gives them some bond characteristics and that could work quite well in the portfolio.”
Alternative risk premia
Another option is alternative risk premia, which Dietz explained is the systematic trading of strategies with the hopes of generating a return without exposing the portfolio to either bond duration or higher equity risks.
“On the risk management side, a very straightforward hedge bonds hedged any risk to the assets that we have in a portfolio,” he said.
“Going forward we need to be more selective in our risk management, trying to see which one's are actually sensitive to which other or to which one a portfolio is sensitive to. Some ESG risks, for example, or some more geopolitical risks.”