Investors who are relying on one form of fixed income to diversify their portfolios and defend against equity volatility are putting themselves at risk, according to the T. Rowe Price multi-asset team.
A popular approach to multi-asset funds is the standard 60/40 of equities and bonds, intended to provide relatively balanced exposure to growth and defensive assets.
For years, this strategy had worked well, but rising volatility has exposed that bonds and equities were not always negatively correlated.
One of the most prominent examples of this was in 2022, when equities and bonds fell in unison rather than being negatively correlated. In 2022, the MSCI World fell by 7.8%, while the Bloomberg Global Aggregate slid 5.7%, according to data from FE fundinfo.
See also: In a volatile world, diversification must go beyond 60/40
For some, this has demonstrated the 60/40 portfolio is no longer appropriate for modern investors.
However, for Yoram Lustig, multi-asset manager at T. Rowe Price “the 60/40 isn’t dead, but you need to be far more sophisticated about that 40%, that defensive investment in particular”.
“It’s a challenging period for multi-asset right now because everything is going down. You need to diversify your diversifiers.”
This is particularly important in asset classes such as gilts, he argued.
Two decades ago, gilts yielded around 4.5%, but investors were “practically getting paid for buying them” because they were so cheap. This allowed them to provide insurance during periods of equity market volatility, he noted.
“These days are gone,” Lustig said. “You can’t trust the gilt market to provide diversification in the way you used to.”
If there are reasons to doubt the stability of the UK market, or there are expectations of a sell-off, then both gilts and UK equities will underperform, he explained.
This has been the case recently, with the Bloomberg Global Aggregate UK Government Float Adjusted index and the FTSE All Share down 3.8% and 7.3% respectively as investors have grappled with the geopolitical conflict in Iran.
Similarly, Lustig said corporate bonds are “not good diversifiers of equity risk” anymore.
In good times, investors do not need to worry about corporate bonds because equities are delivering, he said. By contrast, when investors need diversification the most, corporate bonds may also decline as they did in 2022, he explained.
“Corporate bonds are highly correlated with equities at the worst times.”
This is because corporate bonds, as a form of company debt, are just as tied to the health of the economy and wider business as equities, he said. As a result, if the wider situation is challenging, both will underperform.
Meanwhile, “high yield and emerging market debt are almost more correlated with equity markets than they are with high-quality government bonds”, Lustig added.
In these markets, defaults can jump sharply, and spreads can widen much faster than expected. While the higher income on these bonds can be attractive to some investors, they offer very little diversification to equities, the multi-asset manager noted.
Therefore, he said investors need to be much more sophisticated in building a diversified portfolio and cannot just rely on a single type of bond or debt instrument.
See also: Darius McDermott: Do investors need to rethink portfolio diversification?
To achieve this within their portfolios, Lustig’s team uses the Bloomberg Global Aggregate Bond index as a starting point. As a baseline, this has roughly 40% US bonds, 20% in Europe and around 10% in China and Japan.
This starting point offers a “nice mixture of high-quality bonds” from across the globe, including treasuries, corporate bonds, German Bunds and even some of the better-performing bonds in China, he explained.
Most of this exposure is hedged back to sterling, he said, to avoid currency risk. However, some alternative currency exposure can be a good thing in your fixed income allocation, Lustig explained, particularly if it’s to a strong currency.
As a result, Lustig’s team holds some unhedged treasuries to gain exposure to the dollar. He noted this has been a helpful allocation during the recent conflict in Iran, when the dollar regained some ground as a safe-haven asset after underperforming last year.
See also: ‘There is no alternative to the dollar’: Experts debate the outlook for the world’s reserve currency.
“We can debate if the US has lost its status as a safe haven currency, but as you can see, it appreciated when war broke out, so it still has safe haven status for us,” Lustig said.
Finally, the team has some exposure to alternatives. Within that defensive bucket, the team includes its in-house total return strategy, which invests in a diversified portfolio of bonds and other debt instruments.
