While government bonds have been the go-to safe haven for investors, BlackRock strategists warn that the market backdrop could be threatening their ability to play their traditional role in portfolios.
Bonds have enjoyed a strong bull run in the past few decades, fuelled by the ongoing search for income and, more recently, by the unconventional monetary polices of the world’s central banks.
Indeed, as the chart below shows, the MSCI AC World index is up close to 218 per cent over the past 20 years but bonds in the Bloomberg Barclays Global Aggregate index have still made an impressive total return of 168.83 per cent.
Performance of equities and bonds over 20yrs
Source: FE Analytics
In the UK, government bonds have beaten equities over the past two decades. FE Analytics shows the FTSE All Share has made a 160.29 per cent total return over this period; the Bloomberg Barclays Sterling Gilts index is up more than 200 per cent.
One of the main reasons for owing government bonds has been their tendency to rise when stock markets fall, offering a defensive element for portfolios. However, strategists at BlackRock question whether this will still be the case given the current market backdrop.
A note from BlackRock chief fixed income strategist Scott Thiel, global head of sustainable investing Brian Deese, head of responsible investing for global fixed income Ashley Schulten and head of global sustainable research and data Andre Bertolotti suggested “a rethink” of the strategic role of government bonds in portfolios is needed.
They argued that the outlook for government bonds is being affected by factors such as monetary policy hitting its limits in stimulating growth, interest rates in some developed markets reaching the lowest point they can feasibly go and the increased duration of bond indices (which makes them more sensitive to moves in rates).
“One consequence of rock-bottom rates across the developed world: some government bonds may have diminishing ability to cushion multi-asset portfolios against large drawdowns in equities,” they said.
Equity and bond returns since 1 Aug 2019
Source: BlackRock Investment Institute, with data from Refinitiv Datastream, Nov 2019. Returns are rebased to 100 as of 1 Aug 2019. Indexes used are the MSCI World and Datastream 10-year government bond benchmarks
“The chart above gives a glimpse of this challenge – which we see remaining relevant on a strategic horizon. Equity and US treasury returns were generally mirror images of each other during the August equity sell-off and corresponding recovery, but German government bonds (bunds) offered less of a cushion against the equity sell-off.
“US treasury yields fell sharply, but the decline in bund yields stalled at record lows, suggesting investors saw limits to how much lower bund yields could fall. When risk appetite returned, bunds sold off more sharply than US treasuries.”
The “reduced ballast and meagre expected returns” being seen in some core government bond markets mean investors should not automatically consider the asset class to be a starting point for the defensive side of a portfolio.
BlackRock’s strategist noted that government bonds have traditionally played four key roles for investors: a source of returns through income and capital gains; a perceived safe store of value; ballast and liquidity in risk-asset sell-offs; and (for some types of investor) a means of meeting regulatory and capital requirements.
“The post-crisis monetary easing has propelled a rally in government bonds, aiding the performance of diversified portfolios such as a traditional ‘60/40’ split of equities and bonds. Today’s low yields mean that we should not expect such returns from bonds in the future,” they continued.
“The dramatic drop in government bond yields this year, taking nearly a third of global bonds into negative-yielding territory at one point, has raised serious questions about their role in strategic asset allocations.”
These issues are not being seen everywhere, with the asset management house still seeing merit in US treasuries but not in European or Japanese government bonds.
ECB deposit facility rate over 10yrs
Source: European Central Bank
Interest rates in the eurozone are already in negative territory and could be nearing their ‘effective lower bound’ (ELB), or the minimum level of interest rates that central banks can feasibly set. It’s a similar situation in Japan.
BlackRock explained that short-term rates fall toward their ELBs, bond yields follow them down and bonds’ risk/return profile becomes increasingly asymmetric, increasing the chances that portfolios could be vulnerable to equity market sell-offs.
“Bond prices have more room to fall materially than rise materially in response to broader market events or shocks. Falling yields mean that the compensation for holding duration in the euro area and Japan has collapsed,” the strategists said.
“Increasing low or zero coupon issuance is increasing the average duration of benchmark bond indexes. This makes them more sensitive than in the past to swings in interest rates, with potential for greater volatility.”
In addition, they said any weakening in the negative correlation between stocks and bonds that has prevailed for most of the last 20 years would be another risk to the ballast properties of government bonds.
Factors that could put this inverse correlation under pressure include policy shifts – such as an increase in the use of fiscal stimulus – or a supply shock from any lurch towards deglobalisation.
“Bottom line: The current ultra-low yield environment challenges the role of government bonds as portfolio ballast,” BlackRock’s strategists concluded. “We prefer to overweight higher-yielding US government bonds in strategic asset allocations and see a diminished role for euro area and Japanese government bonds.”