04/09/2021 | Press release | Distributed by Public on 04/09/2021 04:35
It is vital that investors are selective when choosing bonds and funds to include in their portfolios. Not only do some bonds rise in price at the same time as others are falling, some bonds are more likely to follow the direction of the equity market than that of the bond market. This has crucial implications for portfolio diversification.
Equity-like risk from a bond fund is fine if that's what an investor wants but it is clear many of the more aggressive bond structures do not provide diversification from equities, and this is perhaps not fully understood by all their investors.
Many investors use bonds to diversify their portfolio risk. At times of stress, if equites and other higher risk assets are falling, bonds are believed to be a relatively stable asset class that might rise in price as riskier ones fall. This all has to do with correlation:
Most people assume bonds and equities are negatively correlated, hence the benefit that bonds provide to portfolio diversification. But is this always the case?
For a decade, it hasn't really mattered too much which assets you invested in. Central banks have used their authority to try to ensure most assets move in the same direction - for them, rising prices are good! However, there is a chance that central banks will become more comfortable allowing markets to do their own thing: equities might go one way, bonds the other. And, therefore, portfolio diversification might start to matter again. For investors, it won't just be about how many bonds they own, it will be about which type of bonds. Extending this, the type of bond fund an investor owns will be crucial.
What is the evidence? If we look at the UK Gilt market, year-to-date losses (to 31/03/21) are around 7.5%. Gilts are normally fairly stable but fears of reflation and of better-than-expected economic performance have pushed prices down. At the same time, the FTSE 100 has risen over 4% - again as expected, corporate earnings rise in the 'good times', making equities more valuable.
Is this pattern repeated across the bond market? This is where it gets interesting - some parts of the bond market have actually risen in price year to date. In other words, they are positively correlated to equities and negatively correlated to other bonds. If your bond fund is full of these assets, then your risk is not diversified; rather it is aggregated.
The chart below shows the return for gilts and the FTSE 100. In addition, I have included three types of non-government bonds:
To no surprise, the assets that seem most equity-like have risen year-to-date following the path of the equity market. High yield has also risen because during times of rising inflation, companies with lots of debt on their balance sheet tend to do well. Hybrid debt has fallen in value, but much less so than the wider bond market.
Therefore, you really need to be careful what your bond fund owns. Very few core parts of the market have made money year to date. Those that have are often more closely correlated to equities than bonds. This is fine if the investor wants that kind of risk. However, it is clear many of the more aggressive bond structures do not provide diversification from equities. Instead of chasing the lower reaches of the bond market, why not invest in equities as well as a core bond fund?
At Liontrust, we try to keep it simple. We have three strategies - one that is at times negatively correlated to government bonds; one with small, positive correlation; and one which is flexible but generally has greater correlation:
Liontrust GF Global High Yield Fund- we do not hide the fact that high yield carries risk and in the short term at least may be correlated to equities.
Liontrust GF Absolute Return Bond Fund- this has a small, embedded correlation to the bond market. Again, as bond markets plunge, we expect to lose a small amount of money but this tends to be much less than the wider market.
Liontrust GF Strategic Bond Fund- this is a bond fund. Generally, when government bonds fall, this Fund will also fall. However, the Fund is flexible and follows a value-based process - we knew bonds were expensive at the start of the year, so were positioned accordingly.
For a comprehensive list of common financial words and terms, see our glossary here.
Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Global Fixed Income team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The value of fixed income securities will fall if the issuer is unable to repay its debt or has its credit rating reduced. Generally, the higher the perceived credit risk of the issuer, the higher the rate of interest. Bond markets may be subject to reduced liquidity. The Funds may invest in emerging markets/soft currencies and in financial derivative instruments, both of which may have the effect of increasing volatility.
The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.