Investors should own government bonds for diversification purposes as the market is not pricing in a high enough level of risk, according to Allianz’s Mike Riddell.
Additionally, investors ploughing into high yield debt in the hopes of diversification are running a “dangerous investment strategy” as the asset class moves in the same direction as equities.
Having previously looked at why government bonds are good value in relation to interest rates on Wednesday, the manager of the Allianz Gilt Yield fund said regardless of valuations there is a strong case for owning gilts on diversification grounds.
“Gilt prices are driven by other things and not just interest rates,” the manager of the £1.3bn fund said, with another key issue being the level of risk priced into the market.
“Everywhere volatility is just unbelievably low – it is back to pre-2008 levels – and the market is saying that nothing can possibly go wrong,” he said.
Indeed, volatility as measured by the VIX index, is at its lowest level since before 2008 as the below chart shows.
Market volatility index over 10yrs
Source: CBOE
This particularly stable period has been partly due to a strong economic backdrop, with data from the eurozone, emerging markets, US and UK all improving.
It has also been influenced by the market’s confidence that should another crisis take place central banks will step in with further monetary policies and quantitative easing.
This has led to investors being overly aggressive with their portfolios, backing high yielding bonds and equities that will not protect investors on the downside, but are good holdings during bull markets.
“As Warren Buffett said when everyone is being extremely greedy – which they are being right now as they are grabbing yield and forgetting about the risk – you want to be fearful,” Riddell said.
“I feel like we are in that situation right now where financial markets generally are not pricing in enough risk and that the risk of something going badly wrong is much greater. 
“Just in the last week Catalonia is a good example of that where going into the weekend Spanish bonds had not really underperformed at all,” he added.
The Catalan leader announced the state’s declaration of independence from Spain following last week’s referendum but immediately suspended it creating confusion and prompting the Spanish government to seek clarification before taking further action.
“This is not a small issue, this is really big. What I imagine will happen is that it will escalate to the point where the Spanish have to send in the military but then are you actually going to get a revolution? It is entirely possible,” the manager said.
“It is not like the Scottish referendum where everything was being done by diplomacy, there are some hardliners who will just beat people up and force the issue.”
However, the market is not pricing in any wider implications such as financial stability of the banking system and the state of the Spanish sovereign debt, he added.
“That is a possible scenario and the market is just not considering that as having wider implications but it does because it is the rich bit of Spain,” Riddell (pictured) noted.
This is just one source of potential risk that the market is not pricing in however, with the ongoing war of words between North Korea and the US another potential threat.
“Let’s say we have a nuclear war in Asia, what do you think is going to happen in financial markets? Well they are not pricing in any risk of that at the moment so there would be a really violent move,” he added.
“Wherever you look and that is just the known unknowns – there are always things that could happen that no one has even thought about yet.”
Traditionally fears of such scenarios have resulted in asset classes offering a risk premium, but there is none in the market at the moment with many looking fully valued, he said.
“Within therefore a diversified, broader portfolio, I absolutely think that there should be some safe haven assets. Particularly right now – when the market is not pricing anything going wrong – is the time you are going to want them,” the manager said.
“That is the case for owning government bonds for diversification purposes let alone if we think gilts are good value or bad value which as I [have] said I think are looking reasonably okay.”
Investors, however, have been shying away from the asset class in favour of corporate bonds and I particular higher yielding bonds and emerging market debt.
This is the wrong move for diversification, Riddell argued, as they are more correlated to equities than many people realise and will not therefore protect a portfolio should there be a market shock.
Performance of indices since Dec 1998
Source: FE Analytics
Indeed, as the above chart shows, while the Bloomberg Barclays Global High Yield index has significantly outperformed the MSCI All Countries World index since 1998, they have a correlation of 0.71.
According to FE analytics, a strong positive correlation is a figure of 0.7 or higher, while a strong negative correlation is a figure of -0.3 or below.
“So everyone has been piling into this yield chasing behaviour in fixed income and their portfolios as a result are highly correlated,” Riddell said.
“You have your equity portion and your bond portion and they are essentially doing the same thing – going up and down together. I think it is a real danger that a lot of people are underweight fixed income but particularly the bit the own behaves like their equity exposure anyway.”
Investors choosing these riskier, more correlated asset classes is a result of underestimating potential outside risks such as the ones highlighted above.
Indeed, if these assets were paying investors a risk premium, with yields 5-7 per cent ahead of government bonds, the manager said it would make sense.
Yet in some places, for example Europe, the spread is as low as 2 per cent, he said. “You are simply not getting paid enough extra yield or getting enough extra return to go into high yield bonds.”
“Don’t forget that high yield bonds are called junk bonds for a reason – because they are at a high risk of going bust on you,” Riddell added.
“You don’t want 2 per cent extra yield for lending to a country where that risk of default is quite high just because that is what the credit agency is telling you.”
“What it means is that if everyone is doing this and if that is what has caused the credit spread to shrink it means that when something does happen and volatility does pick up, doubling up like that is highly dangerous as an investment strategy.”