Investors need to be open to ways of protecting portfolios other than the traditional approach of loading up on government bonds, as the safe haven’s defensive characteristics were called into question during the coronavirus crisis.
While government bonds have traditionally acted as portfolio ballast during stock market sell-offs, the asset class has been increasingly correlated with equities and some doubt it can protect portfolios like it used to.
Below six investors highlight some alternatives to government bonds for both defensiveness and income.
Asbjørn Trolle Hansen, head of multi-assets at Nordea Asset Management, said “traditional diversification is no longer able to protect investors to the extent they have been used to” in today’s low-yield market with high volatility.
The risk premia currently on large parts of conventional assets does not look appropriate in the “increasingly complex market environment”, Trolle Hansen said, and he has turned to currency as an alternative during the coronavirus crisis.
“Attractively valued currencies can provide pleasantly defensive characteristics – the simplest example being the Japanese yen versus the euro,” he said.
“The historic stress test-like environment investors went through in March proved sound liquid alternative solutions were able to truly diversify – while duration was not.
“During the height of the crisis, it was our proprietary alternative, directional and defensive risk premia that powered the strong resilient performance for our MA Alpha portfolios.”
Credit default swaps
In the past, investors used risk assets such as gold, cash and treasuries as an effective market hedges but Andrew Lake, manager of the $537m Mirabaud Global Strategic Bond fund, argued that “effective hedging […] much harder to come by today”.
After a decade of quantitative easing both volatility and liquidity have reduced, while the correlations between usually polarised asset classes has increased. This has eroded their defensiveness, meaning that when the coronavirus crisis came in March these ‘traditional’ risk assets were swiftly sold off in the scramble for liquidity.
Lake has turned to credit default swap indices (CDX) as an “easy and effective way of hedging underlying credit risk”. Credit default swaps (CDS) are financial derivatives that act as an insurance on the default of an obligation.
“While the constituents [of a CDX] are not reflective of the underlying high yield market, nor your portfolio, such indices provide directional protection at times of extreme valuations, via hedging the ‘beta’,” he said.
“At other times, such instruments are less effective, given the vagaries of individual credit moves, plus other short-term drivers of volatility. There is also a cost, given the 5 per cent coupon, so the hedge is not appropriate as a longer-term position – unless you are confident the sell-off will be greater than the lost carry.
“We certainly benefited from using CDX during the March sell-off and would use these hedges in the future.”
Arif Husain, head of international fixed income at T. Rowe Price, believes diversification did not fail during coronavirus crisis, rather the problem was that investors weren’t diversified enough going into the sell-off.
He said: “Too many investors lost the discipline of pure diversification. They switched from treasuries into things they believed were very similar to treasuries – like investment-grade credit – only to discover that they were not that similar during a crisis.”
Longer-duration assets such as US treasuries can still work as portfolio hedges against market volatility, Husain said, because “when a crisis happens, people will still look for the highest-quality assets”.
Husain said investors had both time and warning ahead of the coronavirus sell-off to increase portfolio diversification and hedge risk as market indicators such as the VIX were trading at historic lows.
VIX represents the market's expectation of 30-day forward-looking volatility of the S&P 500 index. A low VIX is often seen as an indicator of investors’ complacency, meaning they’re too relaxed about potential risks and can be a signal of strong, future volatility and a sell-off in US equities and other risk assets – although this isn’t a proven correlation.
“It is painful sacrificing potential returns, but in the real world, diversification is a form of insurance. And the worst time to try to buy insurance is when the building is already on fire,” Husain concluded.
UK housing market
Alex Pilato, head of housing and capital markets at Gresham House Asset Management, noted: “Covid-19 has wreaked havoc across financial markets in recent months. The dilemma for investors now is how to insulate a portfolio from any potential long-term equity market correction.”
He said the UK housing market is a “good hedge for inflation”, since the costs of housing, rents, mortgage costs and council tax payments partly make up the goods used to calculate inflation.
“In other words, there should be some level of ongoing correlation between inflation and UK rents and house prices,” Pilato said.
“Moreover, the market opportunity in the housing sector is large and portfolio diversification is much easier when compared to commercial property, where individual underlying investments may cost tens of millions of pounds.”
Gold is a traditional ‘safe haven’ defensive asset as it usually rallies when markets fall.
Gold has rallied well along with US equities after the sell-off, with the yellow metal rising to its highest price level in years. Year-to-date the price of gold (shown by the Bloomberg Gold Sub index) has risen 27.60 per cent.
Ropers said that he holds gold as a defensive asset for several reasons.
Firstly, the case for gold has strengthened since interest rates hit historic lows and yields on fixed income assets moved lower and lower, allowing investors to overlook the metal’s non-yielding status.
Second, “gold provides a natural hedge against increased volatility”, which Ropers said has been demonstrated in the crisis.
Finally, he added, “the massive injection of global stimulus, in response to the pandemic, will support the case for gold, as an inflationary hedge”.
Another alternative investment that investors might wish to consider is infrastructure assets, which Liam Thomas – chief investment officer at US Solar Fund – said “can provide a steady, long-term income stream due to cash flows generated by providing essential services like electricity, water, roads and transport – like railways and airports”.
Thomas said that if these services are provided under contract with an investment-grade counterparty they “can provide an attractive alternative to traditional fixed income”.
He added that with UK gilts trading at historic lows, he expects investors to turn more towards infrastructure investments to provide attractive income levels without taking on the added risk of higher yield fixed income investments.
The manager said largescale solar projects, more commonly seen in the US, are an example of this, as the plants have long-term power purchase agreements of about 10-25 years with investment-grade energy purchasers, creating long-term cash flows.
“This reduces the correlation with other investments and increases cashflow stability and predictability for investors,” Thomas said.