It is a good question and one I have been hearing a lot lately.
Traditionally it has been accepted that one of the best ways to protect oneself from steep equity market falls is to include high quality bonds in a diversified portfolio. Usually, we would expect to see higher concentrations of bonds lead to lower volatility when stock markets around the world encounter turbulence, so why isn’t that happening now?
In a typical market cycle, the economic conditions that might lead to an equity market correction, are often the same conditions that favour bonds. As an economy contracts for example, interest rates tend to fall to help businesses and consumers with the cost of borrowing, this reduction in interest rates makes the fixed income yield of a bond more attractive and, as result, prices of bonds go up while equity prices are falling.
In a 50/50 portfolio of equities and bonds, if the equity market falls by 10% and the bond market rises by say, 4, then the net loss is 6% and not the full 10% experienced by equities. In these circumstances the bond holding has done its job in mitigating the worst of the falls.
What we are seeing now however, is something of a perfect storm, even for the most highly diversified portfolios; currently there really is nowhere to hide.
The following is taken from some interim commentary by Evidence Based Investments (EBI) whose expertise we employ in constructing and managing our portfolios.
“Current Situation
The current situation is rare in that both equities and fixed income have been falling. High inflation and fears of a slowing growth rate have been headwinds to both asset classes and headaches to central banks.
Inflation concerns have rapidly increased in the first half of the year. While central banks thought inflation would partly normalise and take care of itself in 2022, they were blindsided by the sudden Russian invasion of Ukraine. Russia is also a major energy and commodity producer providing roughly 10% of the global supply of oil and supplying Europe with around a quarter of its crude oil imports and 40% of its natural gas imports. The sanctions put in place have therefore affected energy and commodity prices, pushing them exponentially to extreme levels. This has intensified the surge in inflation, supply chain disruption, and the risk to global growth. The biggest issue we are seeing is when certain industries can pass off inflationary pressures to the consumers: prime examples are the energy, automotive and retail industries.
Why are bond prices falling?
The main narrative is the shift in gears by the central banks on hawkish stances which has led to further downward pressure on bond prices. The market environment is rare in that bonds and equities are falling in the same direction due to inflationary pressures. The unfortunate events taking place in Ukraine have exacerbated inflationary pressures due to the unexpected inflation created.
For a bond, one of the risks incorporated into a bond’s price comes from interest rates. Since we are currently in a high inflationary environment or heading towards a period of higher inflation, the increased inflation will tend to be countered by an increase in interest rates to steer the economic growth rate to a sustainable level and soothe inflationary pressure. Bond prices have an inverse relationship to interest rates, therefore when the cost of borrowing money rises (when interest rates rise), bond prices usually fall, and vice-versa. The Bank of England has recently increased the base rate multiple times within a short period, with the market pricing in further increases expected throughout the year. EBI portfolios are well-positioned to weather this type of environment due to the effective duration of our bonds. Our average effective bond duration is short-dated (4.3 years compared to 7 years of the Bloomberg Global-Aggregate) and duration can be interpreted as the measure of the sensitivity of a bond’s price to changes in interest rates. Therefore, the bond portion of our portfolio has reduced risk stemming from interest rate rises compared to longer-duration bonds. Short-duration bonds are closer to maturity and have fewer coupon payments remaining, nevertheless, we are not immune to market events.
Conclusion
With the current economic climate, it’s easy to be sucked into flashfire reporting using a short-term lens. It’s important to remember the primary role of bonds in a well-diversified portfolio, the bond portion of the portfolio is there to offer stability against the increased volatility of equity markets over the long-term, and shorter-duration bonds inherently have less inflation and interest rate risk and provide better protection and a smoother path.”
The following chart shows how EBI’s higher concentration of shorter-dated bonds has led to lower falls than the bond market as a whole, scant comfort though that may be during this difficult period.
As I have been explaining to several clients, at some point the economic weather will change and with it, investor sentiment. In the Sunday Times this week and in a couple of blogs I have been reading, there is already talk of the falls in both bonds and equities possibly being overdone and that the gloomy outlook has been more than priced into current valuations. As usual we will just have to wait and see.
I do hope all of the above makes sense but, as always, if you have any concerns about your own financial arrangements or would like to discuss whether you are truly making the most of your money, please do not hesitate to call me.
With kind regards,
Yours sincerely
Graham Ponting CFP Chartered MCSI
Managing Partner
