Long-treasured rules of portfolio construction should be reassessed in light of the extreme circumstances that have hit both bonds and equities in the years since the global financial crisis, according to analysts at Deutsche Bank.
A paper from the bank – The bond and equity switcheroo – argues that the behaviour of these two asset classes has deviated significantly from their traditional performance traits in recent time. “In fact, their performance suggests an historic switching of roles,” the paper said.
The paper was written by head of thematic research Stuart Kirk, strategist John Tierney and research analysts Rineesh Bansal, Sahil Mahtani and Luke Templeman.
The line between bonds and stocks has been blurring for some time, the researchers note. Over the past 10 years, 10-year US treasuries have made an annualised total return of around 6 per cent; this is close to the 7 per cent annualised from the S&P 500 and the difference between the returns is half the average of the past 30 years.
Performance of indices in US dollars over 10yrs
Source: FE Analytics
“But it is the source of these returns that makes the two asset classes seem increasingly interchangeable,” the analysts added.
“It seems investors now buy equities for income and bonds for capital gain. Half of treasury bond total returns in the past 10 years was due to capital gains, up from one-fifth in prior periods. In contrast, the proportion of capital appreciation in S&P 500 total returns has been falling since its peak at the start of the millennium, accounting for two-thirds of total stock returns in the past 10 years.”
Deutsche Bank says investors have to take note of the contribution of capital gains in bond and equity returns because a low share of capital gains in stock market returns has historically been a pre-cursor to subsequent high returns and low volatility from equities.
However, on the other side of things, the future could be tougher bond investors, who have relied heavily on capital gains over recent years. The fixed income derivatives market is currently pricing in a 20 per cent chance that total returns from 10-year treasury bonds will exceed the dividend yield on the S&P 500 over the coming decade.
“Even less likely is that bond returns will match their own performance of the last 10 years – in fact based on bookmaker odds, it is more probable Kanye West will occupy the White House come 2020,” the paper said.
Bonds becoming like equities
The crux of Deutsche Bank’s research is that the recent behaviour of bonds bears “scant resemblance” to the traditional characteristics of fixed income assets – in fact, they are starting to look more like equities.
It gives the example of a portfolio of 10-year US treasuries, which is rolled over into the latest “vintage” every month. This strategy would have achieved annualised total returns of 5.5 per cent over the past decade, which is in line with the average of any 10-year period over the last 40 years.
Share of capital gains in total return over a rolling ten-year period
Source: Deutsche Bank
“Look more closely, though, and the source of those returns has morphed beyond recognition. In the most recent 10-year period, almost half of the total nominal returns was due to capital gains, with the other half from coupon income. Compare this with the prior 10-year period when capital gains accounted for less than one-fifth of total returns,” the analysts said.
“Indeed, the proportion of capital gains in total bond returns is now the highest in at least half a century and twice the long term average. This increased reliance on capital appreciation runs counter to the expected behaviour of fixed income securities.”
Equities becoming like bonds
On the flipside, the paper argues that stocks have been behaving more like bonds recently. The S&P 500 annualised total return, for example, is barely beating treasuries at 7 per cent, while the share of gains coming from dividends has grown to around one-third.
Annualised total return over rolling ten years from holding the S&P 500 and ten-year US treasury bond
Source: Deutsche Bank
“The capital appreciation share of equity returns climbed steadily from 1980 onwards to peak at nearly 90 per cent during the dot com bubble and has been in decline since,” the researchers said.
“Barring some extremes during the financial crisis, the last time equity market total returns were this dependent on dividends was the late 1980s. In fact, the share of capital gains in 10-year total returns is the highest for bonds and the lowest for equities in many decades. As the capital gains share in bond returns fast approaches the corresponding level in stocks, the world’s two biggest asset classes look set to fully switch roles.”
Why does this matter?
The big question though is why should investors care if they make their returns from capital appreciation or income. Deutsche Bank says the historical performance of stocks “suggests they should”.
During the past 30 years, a higher share of capital gains in past returns has been a strong precursor to lower future returns and higher volatility in the S&P 500.
The bank says that some 80 per cent of the variation in the subsequent 10 years’ total returns and nearly half the variation in future volatility can be explained by the proportion of capital gains in the previous decade of total returns.
This relationship suggests that the current situation heralds a positive message for stock market performance over the next 10 years.
When it comes to bonds, however, the message is less cheery. In order for treasuries to deliver a 2.3 per cent annualised total return over the coming decade, yields would have to fall below zero – something the market is giving a probability of just 20 per cent.
It’s not only against equities that the future of bond returns looks challenged. Low and falling bond yields means that it is becoming increasingly difficult for bonds to repeat their historical performance – in order to match the past decade’s 5.4 per cent annualised return over the next ten years, bond yields would have to fall to well below minus 2 per cent by 2026.
Probability of the ten-year treasury yield in 2026 and associated annualised total returns for bond investors between 2016 and 2026
Source: Deutsche Bank
“Even though recent experience shows negative bond yields are possible, imagining 10-year treasuries at minus 2 per cent does stretch credulity,” the Deutsche Bank paper added.
While a simple interpretation of the above could be reduced down to ‘prefer equities over bonds’, the analysts argue that the changing role of the asset classes mean investors have to take a closer look at their portfolios and how much they rely on the performance characteristics they have come to associate with equities and bonds.
“These traits determine suitability for specific investment requirements, for instance, the ubiquitous rule that personal savings portfolios should hold stocks in proportion to a person’s age, with the rest allocated to bonds,” they concluded.
“But the topsy-turvy post-crisis world has changed the behaviour of bonds and equities beyond recognition. Investors planning for the next ten years cannot rely on their old roles.”