Bond indices
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For almost a decade, investors have seen the performance of stocks and bonds move in opposite directions, thereby creating solid diversification within their portfolios.

“Bonds have been a pretty good diversifier, especially over the last 10 years,” says Shailesh Kshatriya, director of investment strategies at Russell Investments Canada. “They’ve been a nice risk offset to have in your portfolios.”

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Michael J. Kelly, managing director and global head of multi-asset at PineBridge Investments, agrees, saying that global bonds had a highly negative correlation to global equity from 2009 to mid-2016: about -0.4.

“Since mid-2016, however, in the reflationary regime characterized by moderate growth and inflation levels, that negative stock-bond correlation dropped significantly,” Kelly says, and is now around -0.2.

Kelly expects that as global demand and supply imbalances stabilize, fixed income will become increasingly uncorrelated to other asset classes. From 2009 to 2016, news events sent risk assets higher and safety assets lower, and vice-versa. “Now, this relationship is less so,” says Kelly.

Further, he says if the world continues to shake off fears of trade wars and Brexit, then correlations between stocks and bonds could hit zero, and even become positive. “In prior overheating episodes, this correlation approached +0.4.”

Even so, clients shouldn’t abandon their core fixed income, warns Kshatriya. “We believe that bonds continue to hold diversification benefits.”

For instance, the returns for the aggregate bond index over the last six months were about 2.9%, he says. Meanwhile, the returns for the S&P/TSX Composite during that same period were -3.9%.

“So you’ve seen a nice risk offset had you had some bonds during the recent volatility in the equity market,” notes Kshatriya.

However, the experts agree that as the correlation between stocks and bonds becomes more positive, investors will have to look for additional diversification opportunities to see growth.

“Investors will have to recalibrate their expectations, look at their underlying portfolios and realize that the easy money in fixed income and equities has been made,” says Candice Bangsund, vice-president and portfolio manager, global asset allocation at Fiera Capital.

The key to creating diversified multi-asset portfolios going forward, say the experts, is to focus on an absolute-return fixed-income strategy, as well as alternative asset classes.

Creating diversified portfolios

An absolute-return fixed-income strategy can help offset market volatility. It doesn’t have a high positive correlation to bonds, yet still provides bond-like risk-and-return attributes, says Kshatriya.

One such strategy is a global unconstrained bond pool, he says, which diversifies the two predominant risks in a traditional bond allocation: credit and interest rates. “It has a return pattern that has a positive* correlation to bond yields,” he adds.

Kshatriya says his firm offers a pool consisting of bonds from countries such as Germany, the Netherlands, Canada and France.

Kelly says another option is a long-short equities strategy that has zero market beta to equity or fixed income. He notes that such a strategy earns a short rebate, which is approximately the Fed Funds rate minus 50 basis points.

“Such strategies actually benefit as rates rise” if they have successful long-short alpha, Kelly says. “Meanwhile, they deliver positive total return without market sensitivity, albeit with alpha sensitivity.”

He uses scientific management to remove residual equity beta and residual factor risks “So the volatility of this sort of alpha is relatively low.”

Another way to diversify bond exposure is to look at slightly riskier options. “Traditional bonds with a lower starting yield, around 2% to 3%, aren’t going to give you that same return,” says Kshatriya. “So that’s why we believe having some global high-yield, emerging markets debt, and convertible bonds all make sense.”

He adds, “These asset classes have favourable correlations relative to traditional stocks and bonds, as well, potentially improving the total return objective of the fixed-income asset class. The caveat being these extended sectors are expected to have higher volatility relative to traditional bonds, so be thoughtful in structuring those exposures from a total portfolio perspective.”

Real assets, such as real estate, infrastructure and agriculture, are also high-income vehicles that are a good alternative to a traditional bond portfolio, says Bangsund. The products are available as direct investments.

“They’ll also do well in an environment of inflationary pressures and higher interest rates,” she adds. “And they lower the overall volatility of the portfolio since they have a low correlation to traditional asset classes. So from a risk-reward perspective, a portfolio would get some diversification benefits, in addition to that additional income requirement that’s not being met by traditional bonds any longer.”

For instance, take a standard 60% equities, 40% bond portfolio, she says. The expected return for the next three to five years is about 4%. The expected yield is about 2%, and the expected volatility is 11%.

If you change that asset allocation to 50% equities, 35% bonds and 15% in real assets, the expected return increases to 4.5%, she explains. Meanwhile, the expected yield rises to 2.7%, and expected volatility goes down to 10.4%.

“Adding these real assets or non-traditional asset classes to the portfolio enhance the income generation while also reducing the overall portfolio volatility, due to their low correlation to traditional asset classes,” says Bangsund.

“So by just adding 15% of those asset classes into the portfolio, that’s going to improve the risk-adjusted profile of a standard balanced portfolio.”

Looking at the duration of fixed income is also important.

“Rather than just buying and holding government bonds, be more tactical about that exposure,” suggests Michael Greenberg, vice-president and portfolio manager at Franklin Templeton Multi-Asset Solutions.

For instance, short-term cash, like 12-month Treasury Bills, are providing good yields. “The return is not anything to jump up and down about, but it’s above zero,” he says.

Also, having more cash in portfolios provides opportunities if rates rise. “Short term, we think rates could rise a little bit more, giving us a better opportunity to add to duration at higher yield levels, at which case you’re locking in a better return,” says Greenberg.

So as correlations between bonds and stocks become lower and less negative, diversification is now more important than ever.

“Make sure you have the appropriate diversification because that’s going to be what will dictate success over the long term,” says Kshatriya.

Tips to offset equity risk

  1. Look at different tools. Some alternative tools are negatively correlated to equity markets, which means they are a good defence to equities in more volatile times. This includes options strategies and factors exposures, where you can get low-volatility and reduce market risk.
  2. Focus on currencies. From a Canadian-dollar standpoint, the Japanese yen and U.S. dollar tend to be defensive currencies for Canadian investors when there are larger equity sell-offs, more concerns about economic growth slowing, or a recession.

*This article was updated on Feb. 27 with a clarification from one of the sources. Return to the changed sentence.