Our Insights

About personal finance, investments and markets.
September 15, 2014

10 year German government bonds below 1% – what this means for your portfolio

German 10-year government bond yields dropped in August to a new record low below 1%. Time to check what role government bonds should play today in a portfolio. We see 3 key take-aways:

(1) Valuation: On an after-tax, after-inflation and after-transaction-cost basis, 10 year German government bonds are likely to deliver negative returns if the bonds are held until maturity.

(2) Porfolio return: a traditional balanced portfolio with 50% equities and 50% government bonds will offer much lower future returns than what investors got used to. With German government bonds yielding 1%, a 50/50 portfolio is likely to offer only muted returns in the region of 3-4% annually. Investors need to transition away from a standard approach if they want to achieve higher returns.

(3) Portfolio construction: Other than valuation, investors need to look at the portfolio utility of each asset class. Investors typically own bonds because it reduces overall volatility. The underlying assumption is that stocks and bonds (reliably) diversify one another, i.e. correlations are stable. However, this is a misguided belief based on cherry-picking data from the last few years. History has shown that there can be long stretches of time, when bonds and equities are actually moving together – as was the case from 1966-1997. If we were to enter a similar regime, a 50/50 balanced portfolio would be much riskier than investors believe. In this case, an efficient portfolio should include a much lower proportion of bonds.

If you would like to discuss how to build an optimal portfolio that enables you to reach your goals, please do not hesitate to get in touch with us at info@ipanema-capital.com.

What follows is a (hopefully not too wonkish) explanation of our 3 key take-aways.

Valuation – is it worth it?
At the beginning of 2014, the yield of a 10 year German government bond was 1.9%. On September 1st, the yield dropped to a record low of only 0.88%. Most market commentators expected a rising yield environment this year. Admittedly, we also wrote on June 18th that the 1.4% yield on offer at that time was already unattractive. If anyone doubts that it can go lower, they should only take a look at Swiss and Japan 10 year government bonds which yielded around 0.5% in August.

We still think the risk-return profile here is highly asymetric. If 10y bond yields were to half, bond prices would only increase by 5%. In our view, this does not compensate for the risk if yields ever were to normalize. But rather than guessing the future path of interest rates, we can say that after taking inflation, taxes and transaction costs into account, today’s 10 year yield is likely to deliver negative real returns if bonds are held until maturity.

Bund 10y - Stand 2014 09 12

Portfolio return – The new normal
Bill Gross of Pimco keeps pointing out that investors should brace themselves for asset returns that will be much lower than historical levels. Why this is the case, can be shown with a standard balanced portfolio that is 50% in equities and 50% in government bonds. Historically the returns were 7-8%. However, if you add to today’s lowly 1% government bond yield the equity risk premium of 5.3% of the last 100+ years, you only get to potenial equity returns of 6.3%. A balanced portfolio will then deliver returns of only 1% x 50% + 6.3% x 50% = 3.7%. Investors that are looking for returns in excess of 3.7% should not rely on a balanced 50/50 Portfolio.

Portfolio construction – diversification effect of bonds is regime-dependant
Why do we add bonds to our portfolio in the first place if the returns have historically been below equities? Because investors think that allocating capital across asset classes represents diversification. In the last 10 years, this has worked well with bonds being good diversifiers to equities resulting in a negative correlation of -0.3. Negative correlation means that bond prices go up when equities go down and vice versa. The whole modern portfolio theorie has been built on the basis of anti-correlation between bonds and stocks. But the inconvenient truth is that bond prices do not always move in the opposite direction of stock prices. In fact, there can be very long stretches of time when the correlation is actually positive. For more than 30 years, from 1966 to 1997, the correlation was indeed consistently positive.

Correlation DB 2

But what if there is a regime shift back to rising correlations again? Correlations can change dramatically, both over time and in different market environments. If bonds and equities were to move in lockstep again, a traditional 50/50 portfolios will suddenly look a lot riskier.

Small changes in correllation can make large differences to asset allocation. Research by Deutsche Bank has shown that a rise from the current average correlation of -0.3% to zero shifts the allocation in favor of equites by 10 percentage points. A return to the average correlation between 1966 to 1997 would even lead to a shift of 25 percentage points.

Risk adjusted efficient portfolio

Diversifying with different asset classes only works if the payoffs are not exposed to the same set of risk factors. We think it is a fair guess that the aggressive monetary policy of the global central banks has been a common driver of valuation across all asset classes recently. Once the monetary policies normalize, average correlations could rise. In addition, the same economic development that took place during 2003-2007 in the US and that led to rising correlations is again in place today:

  • Economic recovery
  • Falling unemployment rate
  • Monetary regime change (Q3 ending in 2014, first rate rise in 2015).

Please read our Terms of Use.