Bonds Behaving Badly

Bond & stock correlation

One of the main reasons to incorporate developed market government bonds into portfolios is because they often move in the opposite direction of stocks and thus act as diversifier. While this negative correlation has held in the last 20 years, bond prices don’t always move in the opposite direction to stocks as seen in chart below.

Longer term this can happen when periods of higher inflation forces central banks to raise rates aggressively leading to both markets falling in tandem, such as in the 1970s. More recently there have been shorter periods where bonds and equities and sold off simultaneously. More aggressive central bank action, or just talk, has caused bond markets to sell off but also equity markets which have become reliant on easy monetary policy for continued gains.

Given equity risk is typically the major contributor, even a more balanced portfolio, having an appropriate set of tools to diversify this risk with minimal cost (negative return) is key.

Current market environment

The US Federal Reserve and Bank of Canada have moved to be more data dependent than they were in 2018. They are setting monetary policy in response to risks around global growth, and with fewer concerns over inflationary pressures they seem content to remain on the sidelines for now. Stock prices have rebounded this year from oversold levels in Q4 of 2019 and bonds have also rallied.

But are we at risk of bonds being less effective at ‘hedging’ portfolio equity risk going forward? The combination of slowing growth and modest inflation seems benign to bonds, but with yields so low their ‘hedging’ efficiency may be somewhat impaired.

In fact, we are reaching all time highs of amount of debt with negative yields meaning it will now cost you to hold government bonds in some regions (ignoring the return pick-up from hedging the currency for a Canadian investor).

How does this impact multi-asset portfolios?

With bond yields very low and risks to equity markets increasing we are looking for a broader range of tools within our multi-asset portfolio that can help us diversify our equity risk in the most efficient way.

One of the ways to do this is to be nimble with the duration exposure within our fixed income allocation. For example, having exposure to different yield curves outside of Canada and using cash more as an active tool is a start.

Secondly, we can take advantage of a broader opportunity set of instruments that help diversify equity risk and typically also exhibit negative correlation. For example:

  • foreign currency exposure such as the Japanese Yen or US Dollar
  • more defensively oriented active managers
  • factor-based exposures such as Quality and Low Volatility
  • more exotic strategies in options (although these approaches can be both expensive and difficult to time in unpredictable markets, so we are not using them currently in our main portfolios.)

Our view on bonds

With global growth slowing and inflation likely to remain contained, the diversification benefits between stocks and bonds should hold. The strong rally in bonds however does leave some room to be tactically more cautious. We maintain higher cash balances as the flatness of the yield curve means opportunity costs are lower to hold cash and will allow us to be nimble to position into higher duration bonds if yields rise.

Longer-term, two main risks are either inflation exceeds targets or growth slows much faster than anticipated. For now, slowing growth is the bigger risk of the two and we are comfortable with our bond strategy at this point and look to continue to add to duration if rates back up to offset rising risks within equities.