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September 28, 2015

Bonds are no longer a good hedge for equities

Bonds play an important role in a diversified portfolio: they provide stability and guaranteed returns. Stability means that bonds typically increase in value during times of distress and thus provide an important hedge against the more volatile equity portion of your portfolio. What many investors haven’t realised though is that bonds are increasingly losing this important stability function. We briefly explain why that is the case and what it means for your portfolio construction.

There is less upside in low yielding bonds

As yields approach the 0% mark they produce less and less potential upside.  The following table illustrates that the upside protection roughly gets cut in half as yields halve.

Change in bond yield: from ..% to ..%Price gains of 10y German government bonds
6% to 3%+26%
3% to 1.5%+14%
1.5% to 0.75%+7%
0.75% to 0.375%+4%

We just need to compare the mini-crash in the summer of this year with the financial crisis of 2008. While the DAX dropped by ~25% from July to December 2008, the 10 year german government bond increase by nearly 15% and thus provided a certain amount of protection. In 2015 however, the DAX lost roughly 20% from July to September but the 10 year government bond barely increased in value at all (only 1%)

2008:

2008

2015:

2015

A traditional 60/40 portfolio shows a very different behavior today

Investors who are used to a portfolio like the traditional 60/40 equity/bond split of the 80s and 90s should not expect their portfolio to behave the same way today. Their 60% stock slice is now generating even more permanent loss risk than ever while their bond slice is acting more and more like a true cash component.  This puts the traditional 60/40 investor in a bind.  They are going to have to start deviating from 60/40 if they want to generate the same type of nominal and risk adjusted returns because there is simply no way their bond component can protect them to the same degree that it once did.  In fact, if rates become more positively skewed in the years ahead the bond piece might even contribute more permanent loss risk in the near-term than many of the investors are hoping for (see further discussion here).

So where does this leave long-term investors?

Bonds are struggling to fulfill their main roles today: they neither provide a satisfactory return (10 year German government bond yields are below the current inflation rate) nor do they offer much upside in the case of a recession to balance out the losses in your equity holdings. A traditional 60-40 portfolio needs to be re-thought. But please keep in mind that you cannot squeeze blood from a stone. It would be a mistake to follow the lure of alternative assets or similar products pushed by banks that ‘promise’ an easy way out. Unfortunately, there are very few (if any) beta sources that offer negative covariance to equity returns; most tend to be positively correlated. Investors will have to accept more volatility in future performance and greater drawdowns. In addition, investors need to take a closer look at their financial plan and see if it requires any changes.

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