Safe-haven bonds show a negative Beta, which means that they tend to rally when equities sell off. But as can be seen, the Beta has become less negative recently.
For 10-year gilts, for example, the Beta now stands at just -0.09, which means that when one tries to hedge a one-million position in global stocks, one would need to put an 11 million position of gilts against this to be hedged.
Over the past five years, one would have needed closer to 6 million to be completely hedged. Of course, investors do not want to take away all potential risks from portfolios, but this clearly shows that bonds have become less effective as a hedge.
This is intuitive: given the very low yields, the potential for positive bond returns is getting ever more limited, even in a scenario where equity markets sell off sharply.
There are many other assets that provide good diversification potential, with Betas near zero.
Although investment-grade (IG) credit has a positive Beta, it is very low. This is a result of the inverse correlation between credit spreads and bond yields, which tends to temper the volatility of corporate bond yields and hence the volatility of corporate bond returns.
Currencies are generally considered to be quite volatile, but what is sometimes overlooked is that some show a low correlation to equity markets.
Therefore, they can be valuable diversifiers. Japanese yen and Chinese yuan positions should allow investors to diversify away equity risk.
When we look for diversification, we would of course rather pick an asset that is cheap over one that is very expensive.
Of all assets, it is clear that gilts and Treasuries are the most expensive. This of course has an impact on IG credit valuations: although spreads are attractive in our view, the very low government bond yields mean that overall corporate bond yields are not very attractive either.
This is why we like to add some high yield to credit portfolios, which offers some more value.
When looking for value, we come back to the currency market: emerging market currencies have sold off substantially in past months and we believe that they could offer some good long-term value in portfolios, even if we foresee short-term volatility as a result of global uncertainties and concerns over the Chinese slowdown.
Commodities is also an area we watch with some interest: oil and others have sold off sharply in the past 12 months, but most commodities do not look that attractive on a five-year history given strong appreciation in previous years. We maintain a neutral allocation to the sector for now, therefore.
It is important to remember that gilts and Treasuries are not the only way to diversify a portfolio.
They have lost some of their diversification potential and are very expensive. In addition, safe haven bonds could well sell off when risk appetite stabilises or the eurozone progresses on a fiscal union plan.
We think credit and currencies can add to the diversification at a much lower cost, and although emerging market currencies are certainly an imperfect hedge for equity portfolios, their low valuations add to their attraction.
We also believe that select emerging market and European stocks, as well as some increased commodity exposure, may make sense once risk appetite stabilises.
Willem Sels is head of investment strategy at HSBC. The views expressed here are his own.