The old 60/40 mix of equities and bonds has been declared dead several times of late following a rancorous relationship breakdown between the two asset classes in 2022.
Since the rare twofer last year of deeply negative returns from both shares and bonds, many investors have been shy of returning to the bog-standard portfolio diversification recipe.
However, Greg Fleming, Salt head of global diversified funds, says the 60/40 approach may still have its merits.
“But you have to ask ‘what’s in the 40’?” Fleming says.
He says investors expecting the same historical portfolio diversification and total return from a shotgun-style bonds allocation risk disappointment in the new fixed income regime.
In a new paper published last week, Fleming argues passive fixed income exposures are unlikely to offer investors safe haven, or return compensation, from the big fiscal and other issues ahead in a world turned inside-out.
“… when the inclusive global benchmarks are taken as the starting point for fund construction, interest rate exposures are determined by how much debt is outstanding and by the maturity of the underlying bonds. This means the largest interest rate exposures taken on by the investors are to the largest and most indebted countries,” he says.
“Today, these countries face common challenges: slow growth, worsening demographics, and, over the last decade, typically low yields. Even as yields have risen sharply in 2022-3, they still may not sufficiently compensate the passive or developed-market-focused investor for longer-term fiscal and/or interest rate risks.”
The Salt report, a follow-up to its 2022 bond study, says while current yields may look attractive, investors need to distinguish among the different risks emerging in regions, countries, sectors and securities in more volatile fixed income markets.
Investors also need to be wary of ‘over-diversifying’ in index-wedded bond funds designed to loosely track a non-investible global benchmark that contains almost 30,000 individual securities.
Fleming says while many NZ investors have been content to allocate to ‘bland’ indexed global bond portfolios as a diversifier to both local fixed income and equities, the “rationale is no longer quite as valid, as bond market volatility has been higher recently than history would suggest was probable”.
“Furthermore, correlations in returns between sovereign bonds and equity markets are also running at 25-year highs. Bond volatility and Equity volatility are mutually re-enforcing at present, rather than mutually mitigating, and therefore the simple blending of generic Fixed Income and Equity exposure for diversification purposes has had disappointing results,” he says. “That opens an opportunity, for forward-looking Trustees and investors to envisage deploying more targeted and distinctive parts of the international bond markets.”
The report says while private debt markets offer some refuge for bond-scarred sophisticated investors, active fund managers can still find value in the more liquid, traditional fixed income universe.
“Arguably, the main global bond benchmarks in common use have deteriorated and become historical artefacts, kept in use mainly through an excessively conservative view as to where risks truly lie in the decades ahead. By contrast, being unconstrained by a benchmark allows the better funds to focus on delivering consistent, uncorrelated returns from various sources of bond excess return – which also reduces market directional risk.”
Fleming says with short-term yields at highs not seen for a decade or more, NZ financial adviser might be able to lock-in gross annual returns of 6 per cent or more in a laddered term deposit portfolio.
But with the potential of higher yields and capital gains in bonds as markets reprice from rate peaks over longer periods, investors need to carefully reconsider fixed income allocations outside the short-term timeframe.
The Salt global fixed income portfolio, managed by Morgan Stanley, has a current average duration of 2.8 years – quite short by historical standards, Fleming says, but with flexibility to adjust as the manager sees opportunities.
And the Morgan Stanley fund holds only 230 or so of the roughly 30,000 global bonds in the benchmark.
“Index bond funds are very monolithic,” he says, noting that most investors would have very little idea of the portfolio contents with some opaque labelling practices.
“Some bonds only have a numerical identifier – so you can’t easily see what they are.”