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Nothing ventured, nothing gained
THE bond market has been correcting in recent days, and the same can be said to a more severe extent for stocks. Investors have been calling for an end to the bond bull market for years now, and they have been proven wrong year after year. Bond investors who have experienced the debacle from 1980 to 1981, would have seen 10-year US Treasury yields soar a whopping 650bps during an era when the Fed hiked key rates from 9.5 per cent to 20 per cent.
It was a period of the largest losses for the bond market in American history. The maximum drawdown for long-term bonds then came in just under 21 per cent - the only registered bout of losses exceeding 20 per cent for US government bonds.
When we consider the fact that coupon income accounts for a major portion of total returns for fixed income, that provides some buffer against the capital losses on the bond price.
For this reason, the well-known "bond market bloodbath of 94" saw total losses at 3.35 per cent, while the taper tantrum of 2013 saw total losses at 3.35 per cent - not quite what one would define as a bear market.
Several factors such as sustained growth and rate hikes may exert pressure on this asset class, but the pillars for fixed income markets remain engaged - political uncertainty, high US government debt, and US Treasuries' relative attractiveness versus other developed countries' debt.
The last point packs a weightier punch now with the 40bps jump in yields seen in US treasuries year to date.
Investors vary in their preferences and beliefs and many shun bonds due to their perceived lower returns.
A well-diversified portfolio would put a smile on any Modern Portfolio Theorist's face. For an avid equity investor, it is believed that one should allocate some portion of the portfolio to bonds - for obvious reasons such as recurring income and capital redemption, and for less blatant purposes such as managing the overall volatility of one's positions.
Given the huge gains across global stock markets witnessed last year, portfolio allocations between equities and bonds would have most likely moved away from target weightings. Rebalancing is thus much needed, especially this year.
An Apple investor who has placed all his money in the stock 10 years ago would probably not appreciate the concept of asset allocation nor the Efficient Frontier. Surely hindsight is a wonderful perspective to have, but if we all had it, there would be no history to write about.
The Efficient Frontier is a set of optimal portfolios that provides the highest returns for a given level of risk, that is, a portfolio that defines the perfect balance between risk and return - a theory founded by American Nobel Laureate Harry Markowitz.
The Eureka moment for Mr Markowitz hit when he discovered that the volatility of a portfolio does not solely depend on the constituents of the portfolio, but also on the extent of their movement up and down together - correlation as we call it. Year to date, the stock-bond correlation is best explained by the MSCI Asia Ex-Japan Index versus 10-year US Treasury yields, displaying a negative correlation.
The value of diversification has displayed its usefulness in what we saw as the most recent shake-up in the month of February, after markets tumbled off their highs etched in the concluding week of January.
Portfolios which have allocated all of their funds in equities would have seen as much as a 10 per cent hit, while a 50/50 bond to equity allocation would have seen half that decline.
Diversification works because dissimilar asset classes do not move in parallel and therefore helps to optimise portfolio returns with less fluctuations than one would see in a single asset class over time.
Then comes asset allocation. The combination of asset allocation coupled with the Efficient Frontier is a winning formula. If one has invested solely in Asian equities in 2017, returns would have been as phenomenal as over 40 per cent while the gains for having invested purely in investment grade bonds would have registered a paltry 6 per cent for the same period.
Fast forward a year on, investing in the same equities would have rendered an investor 10 per cent poorer over the span of a week, while the losses for bonds have not quite moved the needle in comparison. Not forgetting the topic of risk - the volatility of taking on exclusively stocks vis-a-vis a stable of bonds can be as vast as tripled. Equities generally bear the burden of 15-18 per cent in volatility, while for bonds' it is 4 to 5 per cent.
Not all bonds are made equal. Corporates with 'junk' status tend to carry higher risks than those with investment grade rating. Other factors such as duration risks should also not be ignored - the longer the duration of a bond, the higher the sensitivity to rates.
Risks and returns work hand in hand. In order for an investor to see higher returns, he needs to be willing to stomach a greater level of risk and this is most commonly done via longer maturity bonds or lower quality credits. Amid compressing spreads on bonds through 2017, investors have inadvertently increased risks in their pursuit of higher yields. Bonds with different characteristics carry different risks and consequently, different returns. It is safe to say that even within the same asset class, diversification can serve as a helpful tool.
Take a simple example of Stock X and Bond Y, with an investment horizon of two years. An investor puts half his money in Stock X and half his money in Bond Y, for both years. Stock X goes up by 10 per cent in the first year and none in the second, with an implied volatility of 15 per cent. Bond Y saw zero gains in the first year and rose by 10 per cent in the following year, with an implied volatility of 10 per cent.
Both securities trade with negative correlation. Due to this negative correlation, an investor would withstand lower volatility of approximately 7-8 per cent, compared to 10 per cent by buying solely Bond Y, or 15 per cent investing purely in Stock X, and all this while, enjoying the same returns over the same holding period.
Introducing bonds into a portfolio of equities will benefit more than one can complain about opportunity costs. Bonds have the edge of carry income, which is why over the past 20 years, the bond market has only seen three years of negative total return, with each not exceeding 10 per cent, and these years have never coincided with a rate hike cycle, nor were they back-to-back years.
In contrast, for equities, the MSCI World Index saw six years of losses, with 2008 falling over 40 per cent in value.
With the VIX index up from 10 to 37 at its peak since the start of the year, volatility becomes a real hazard and portfolio diversification will become more essential to aid one in navigating more challenging market conditions ahead.
Active management via the discretionary portfolio management platform can also add further alpha by employing alternative investments and hedging strategies.
Perhaps it is time we move away from a long-only approach. As the old adage goes: Don't put all your eggs in one basket.
- The writer is head of discretionary portfolio management, Indosuez Wealth Management