The “slow-moving train-wreck” of a bond market has “suddenly accelerated”, MyFiduciary principal, Aaron Drew, told an industry audience last week.
And investors need to get out of the way or risk wealth-threatening injuries.
Drew told the Heathcote Investment Partners ‘Meet the Managers’ March roadshow crowds that investors could no longer rely on bonds for income, capital gains or even portfolio diversification.
He said while central banks could continue to engineer low interest rates for some time, investors can’t ignore the mounting risks in bond markets that included:
- an earlier-than-expected return to monetary tightening policies;
- market pricing-in rising inflation expectations (an event previewed early this month);
- governments struggling to meet their now massive debt obligations; or;
- outright sovereign bond default in one country, potentially sparking another global financial crisis.
“Our view is that even if these risks don’t play out, bond investors will still get dreadful returns over the next few years,” Drew said.
In a just-released note for clients, MyFiduciary says with vanilla bond fund yields hovering around 1 per cent, real returns after fees, inflation and tax would likely sink below zero.
“This has also motivated our search for alternative investment options,” the research paper says.
Drew told the Heathcote audience that while there was “no silver bullet” to replace the previously reliable return and portfolio diversification benefits of sovereign bonds, investors had a few options to consider, some of which follow institutional-type strategies.
“Things can be done to mitigate the risk of rates going up,” he said. “And even if rates don’t rise, it’s possible to get a better running yield and some diversification from a market sell-off [than investing in bonds].”
Firstly, investors could tweak their portfolios away from bonds and into other traditional fixed income assets (or proxies).
The research paper says MyFiduciary had already recommended several changes to portfolios it advises on, including:
- materially reducing the exposure to government bonds compared to market benchmarks;
- increasing the exposure to short-term credit, which has much less sensitivity to rising rates/lower duration than standard bond funds;
- increasing the exposure to investment grade credit overall, which also tends to be much lower duration than government bonds and a higher running yield; and,
- allocating to inflation-proofing asset such as listed property and infrastructure, which perform relatively well in a rising inflationary environment.
Furthemore, investors could look to non-traditional bond replacements such as those used by the NZ Superannuation Fund and the like.
Liquidity demands meant retail investors couldn’t exactly replicate institutional-level bond-alernative strategies, Drew said, but MyFiduciary had identified some platform-ready funds that fit the purpose.
The paper says retail investors looking to fill the income and diversification void left by bonds could select from a number of options that MyFiduciary lumps into two categories: yield-enhancers; and, risk-mitigators.
Private credit, high-yield and insurance-linked securities (ILS) fall under the ‘yield-enhancer’ label while risk-mitigators include gold and “trend-following” multi-strategy funds (offering “crisis alpha”), according to the research note.
An equally mixed portfolio of gold, ILS and ‘trend following’ funds “generated slightly better returns than bonds, albeit with more volatility” in a 20-year back-test, the MyFiduciary report says.
Drew said investors would need to consider the “trade-offs” among the alternatives with more complex risk management an inevitable outcome in a non-bond portfolio.
“No single alternative asset class offers the same combination of acceptable yield and diversification benefit as bonds have historically offered,” the paper says.
The report says the MyFiduciary recommendations are an “attempt to replicate, in sum, the role fixed income has traditionally provided by taking a series of risks that are, as much as possible, independent of those taken elsewhere in the portfolios”.
As at August last year, the global sovereign bond market carried about US$87.5 trillion in freight, according to the International Capital Markets Association: quite a train.