Originally published by Cuffelinks
There’s plenty of material in the market about how yields within the aggregate bond indices are either nominally negative or offer negative real returns. It creates problems for investors seeking to achieve a ‘CPI+’ target just by allocating to traditional OECD government bonds as their portfolio’s defensive anchor.
Many Chief Investment Officers at defined benefit superannuation or pension funds wishing to manage their long-term liabilities with a standard diversified portfolio may no longer be able to consider government bonds a strategic asset class. At best, most OECD government bonds could be considered a tactical asset class, one used to buffer the underlying capital during any expected market correction. Their predicament is further complicated by the on/off debate around when meaningful inflation will return.
Where else to invest ‘defensively’?
Frustrated by their inability to access traditional government bond yields at CPI, let alone above, an increasing number of professional investors have either increased their risk budgets within their defensive buckets (sounds like an oxymoron), or they’ve abandoned the underlying bond indices and embraced specific bond issuer risk. In either case, this is indicative of how investors are looking to redefine traditional exposures, albeit while still under the ‘defensive’ umbrella.
But the risk budget must come from somewhere.
There’s always been some friction between bond and equity departments. More recently, much of this friction has come from the fixed income team now consuming a larger portion of the overall portfolio risk budget. Equity teams can come to resent this as they’re usually the ones asked to reallocate some of their risk budget to keep the overall bond allocation fixed at a Moses’ stone-engraved and highly static 40% level. The fixed income teams push out their risk budgets, while leaving the overall total portfolio risk budget static, and the allocation has come out of the equity teams.
In fixed income, especially for active portfolio managers, this has opened up what was previously a dormant and inactive sphere. What wasn’t passively allocated already was predominantly owned by a few big fixed income houses (or in central bank portfolios). Unlike what’s been happening within the equity world, many fixed income investors seem to be moving away from traditional passive. But here too, even the big ETF and index providers have been negatively impacted as investors have either favoured high risk fixed income options, or complete benchmark agnostic fixed income portfolios. Liquidity and capacity constraints have played against the massive size of the major fixed income shops.
Either way, yields on OECD medium and long-term bonds remain at levels that make it too difficult to assist in pension liability immunisation, or for any investor seeking low risk CPI+ returns. As long as this continues, investors will be forced to seek out alternatives within a shrinking bucket called Fixed Income.
Portfolios lose their defensive character
Investors will either have to push out their risk budgets (through individual bond purchases or through higher credit risk), or seek out bundled solutions which deliver risk and return metrics traditionally expected of a ‘defensive’ asset class. Obviously, these moves take portfolios away from their primary role of protecting capital. It’s like anchoring a boat with too short a slack, until it ultimately pulls the vessel under water.
Investing a diversified portfolio in this market is not easy. If it was, then economics would be an exact science over a social one.