Commentary: Fixed income – the allocator’s dilemma

As concerns about a COVID-19 induced market crisis have receded, asset owners are once again wrestling with questions that became familiar in the post-global financial crisis environment. In a world of historically low interest rates, what place do sovereign bonds have in a portfolio? Is their return outlook finally brightening, and will they remain an effective offset against equity market shocks? What are the alternatives to sovereign bond allocations, and how should investors go about identifying suitable solutions?

The perceived role of sovereign bonds in asset allocation has evolved over the past 40 years during the secular bull market in fixed income. In 1990, with the U.S. 10-year yield around 8%, bonds offered a source of steady income that could meet many investors' overall portfolio return targets. But as interest rates continued to fall, so did expected bond returns. To meet performance targets, asset allocation models progressively pushed investors to increase their equity exposure at the expense of greater overall portfolio risk and, specifically, vulnerability to stock market shocks. Over the past 20 years, however, bonds have provided a reliable hedge against equity market drawdowns, and bond allocations have come to be valued for their risk reduction benefits if no longer for their expected returns.

But in 2021, the outlook for bonds now seems grim in both regards. With respect to returns, while the U.S. 10-year Treasury yield has risen a full point from its 2020 nadir, at only 1.5% it remains not far off pre-COVID-19 lows, and the real yield is negative. Moreover, while signs of reflation have sparked hopes of higher yields, capital losses on existing bond allocations would test the mettle of long-term fixed income investors, offsetting benefits from more attractive reinvestment opportunities that would take time to accrue. On the other hand, if the economy falters and rates fall further, then — despite another unexpected tailwind from rising bond prices — questions about the role of fixed income would become all the more pressing in an even more anemic yield environment.

What's more, investors should not assume that bonds will continue to provide strong equity risk reduction. Such benefits haven't always been the norm — prior to the 2000s (Figure 1), bond and stock price correlations were positive for nearly three decades — and recently, bonds and cap-weighted equity indexes sold off together amid concerns about re-emergent inflation and diminished prospects for large-cap stocks that benefited from COVID-19-driven lockdowns and the need to work from home. In addition, if the economy were to fade, then central bank policy measures might restrict the ability of bond prices to offset equity market drawdowns, similar to the impact of yield curve controls in Japan.

Given the dim outlook for sovereign bonds, the key question again becomes how to replace them. Prevalent approaches tend to fall into two broad categories: direct hedging, in other words embracing higher equity allocations and paying to reduce the associated downside risk, and reallocating to "uncorrelated" assets that are expected to deliver positive returns but with limited exposure to market stress. Finding satisfactory alternatives to replace the role of sovereign bonds has been a challenge, however.

Direct hedging tends to look unacceptably expensive, especially on a systematic basis. As one measure, the price of three months of put protection against U.S. stock market declines in excess of 10% has, over the past decade, averaged nearly 1% of portfolio value. As a result, while large windfalls from hedging programs during market shocks attract attention, many hedgers eventually succumb to "funding fatigue." There are methods to reduce the upfront cost of hedging, but many investors reject the compromises required from transparent methods (which may include limits on downside protection or upside participation) and the complexity of sophisticated approaches.

And while the search for "uncorrelated" investments has fueled the growth of myriad alternative asset classes and strategies, including hedge funds and private markets, many purportedly diversifying strategies are more exposed to market risk than their marketing acknowledges. For example, while hedge funds' returns rebounded in 2019-2020 relative to the prior decade, they did not perform well, on the whole, during the first-quarter 2020 market crisis, emblematic of their "short put–like" vulnerability to equity drawdowns. Private equity and real estate are also more vulnerable to market stress than indicated by their reported returns, which reflect smoothing and other forms of accounting discretion. During severe equity drawdowns, the plunging market valuations of publicly listed PE firms indicate substantial damage to the underlying PE portfolios. While sophisticated PE investors have come to recognize accounting's role in distorting risk characteristics across the asset class, many believe that their particular holdings are idiosyncratic enough that they aren't so vulnerable. Yet a prolonged downturn would likely reveal their economic exposure as levered equities.

So where does this leave investors with respect to fixed income replacements? We would highlight two broad lessons drawn from their experiences over the past 25 years.

First, investors should clarify the specific objectives associated with their bond allocations — with respect to returns generation, risk reduction, and liquidity — and deliberately engineer them into solutions. Gold provides an instructive counterexample. While some investors are championing gold as a fixed-income replacement amid budding concerns about inflation, gold's behavior is more complex than popular discussion acknowledges. Despite its reputation as a reliable equity hedge, gold's price responds to real interest rates, which reflect the relative attractiveness of competing investments. As a result, gold (Figure 2) has suffered losses during equity sell-offs that have been accompanied by rising real yields, including March 2020. Gold can play a useful role in a fixed-income replacement strategy, but it shouldn't be accepted as a standalone alternative by happenstance; its integration into a solution calls for nuance.

Second, investors should embrace process sophistication commensurate with their objectives. Specifically, creating an investment that is genuinely independent of equity drawdown risk and other material asset class exposures will demand sophistication in portfolio formation. It may entail long-short construction that is informed by asset-level risk relationships to neutralize both direct and indirect asset class exposures; dynamic, since risk relationships evolve with the economic and market environment; and tail-focused and forward-looking, to control for non-linear asset class exposures and avoid overreliance on historical experience in evaluating portfolio vulnerabilities. Similarly, generating genuine and repeatable alpha will likely require rich forecasting methods that are tailored to distinct assets, informed by diverse information sources and naturally adaptive to changes in the investing environment. The notion of generating stable outperformance by combining a few broad risk premiums through simple and static implementations is tempting but illusory.

The outlook for sovereign bonds remains grim, and asset owners face no simple challenge in finding suitable alternatives. The investment landscape is littered with strategies that have failed to deliver on promises of risk management or performance commensurate with fees. The appropriate reaction, however, is not to abandon sophisticated investing approaches. Investors should be clear about the economic functions that bonds have served in their portfolios, with respect to risk reduction, alpha generation, and liquidity, and embrace the sophistication necessary to engineer those requirements into the solution. But investors must also avoid complexity that serves only to obscure the economic drivers of performance. No simple task indeed, but doable.

Seth Weingram is senior vice president, director of client advisory, and Ram Thirukkonda is senior vice president, senior investment strategist at Acadian Asset Management LLC. Both authors are based in Boston. This content represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.