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The importance of diversifying your bond exposure

23 July 2014

Trying to time the market may be tempting, but Dr Peter Westaway says the risks tend to outweigh the rewards.

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Is the recent market upset a sign of more volatility to come?

“I mean, if anything we’ve just gone through a period of surprisingly low volatility and I think the recent flare up was a useful reminder that markets are volatile. And in that sort of situation you do need assets that provide you with some of those sort of dampening characteristics, which is what fixed income can do for you.”


How did bonds fare in the recent sell-off?


“Well, what tended to happen was that all risky assets tended to do very badly. So equities, some of the peripheral and high yield bonds, tended to fall in price and then they tended to grind back up again over the last few days. So really, it really illustrates the difficulty that there is of predicting these sorts of flare-ups in advance and the hazards of trying to time the market.”


Is it possible to time the markets?

“Some people think that they can do it but I think the evidence tends to show that active fund managers on average will tend to underperform passive funds or investors that simply hold the overall index. I think the simple message is very often a diversified portfolio across the whole of fixed income will do just as well as trying to be too cute and pick particular asset classes at any one time.”


Should investors move up the risk scale for income?

“You hear a lot at the moment about the so called search for yield in a low interest rate environment. What that’s doing is it’s tempting a lot of investors to go up the risk spectrum to try and eke out more returns.

The danger with doing that is that as you move up the risk spectrum, the fixed income assets that you’re buying are becoming less and less like standard fixed income and more equity-like in their characteristics.

In particular, these assets will tend to display more volatility in the face of shocks and they’ll also not tend to act as well as a counterweight to equities. So when risky equities fall in price, a lot of these other high yield fixed income products also fall in price. So you’re really not quite getting the characteristics from your fixed income that you think you’re getting.”


What about strategic bond funds, which are meant to actively manage risk?

“Again, strategic bond funds sound very tempting. The empirical evidence shows that they’re not always that successful in being able to achieve those goals. I think just as importantly, investors don’t always know what risk they’re exposing themselves to when they buy strategic bond funds. So I think there’s a place for those but I think it’s a strategy which has its limitations.”


Should investors look outside the UK for fixed income exposure?

“I think there are enormous advantages to looking away from your home market and towards the wider global market. Having a UK-only portfolio exposes you completely to the risks associated with the UK market. Interest rates around the world do tend to move up and down together, but they don’t move as one. And so, for example now, even if interest rates may start to move up in the UK, maybe in the US, we’ve still got a situation where interest rates in Europe and Japan are still in easing mode. And so, holding a diversified portfolio of different regionally denominated assets means that you’re getting that diversification of risk. So there are big advantages to holding a global portfolio.”

This video and article were produced in collaboration with and are sponsored by Vanguard Asset Management.

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