Interest rates globally continue to plumb multi-decade lows, or multi-centennial lows in the case of Bank of England (BoE). The BoE reduced rates by 25 basis points (bps) to 0.25% on 4 August, marking the lowest rate setting ever in the 300+ year history of the bank. BoE Governor Mark Carney stressed that more monetary action would be forthcoming if needed. While Mr. Carney ruled out negative interest rates as a policy option for the time being, the UK joining the infamous negative interest rate policy (NIRP) club, of which Switzerland, the EU and Japan are current members is not inconceivable given considerable downside risks to growth and the poor response to the BoE's latest bond buying programme. In this article, we outline some key implications of NIRP and the 'lower for longer' rates regime that we currently find ourselves in.
Bonds are not a safe haven
Every asset class has a role to play in well-balanced, global multi-asset portfolios. Equities provide exposure to growth, commodities serve as a hedge for inflation risk, while nominal bonds have traditionally played the role of a defensive, safe haven asset.
However, a comparison of the relative risk levels of equities and bonds using realised volatilities on each asset class over multiple periods historically, suggests that the level of risk between risky and risk-free asset classes is no longer all that dissimilar (see Chart 1).
Chart 1: Equity vs. bond volatility
Source: Bloomberg and Nikko Asset Management
A similar level of volatility in itself doesn't preclude bonds from being a safe haven asset class if bonds can be expected to perform well when equities are selling off. This is what they have done historically with sufficient predictability that it has become accepted as common investment wisdom. In fact, most multi-asset strategies are based on striking a balance between risk attributable to growth assets, such as equities vs. risk attributable to defensive assets, such as sovereign bonds.
Beware the bond-equity correlation
Chart 2, which plots the rolling two-year correlation between US equities and bonds over the last 40 years, shows that the reality has been quite different. The correlation has been negative for most of the last 15 years, i.e. bonds usually gained when equities sold off. However, this followed several decades of positive correlations when both bonds and equities moved up and down in tandem. Bonds do not act as a safe haven asset class when that happens.
Chart 2: Equity vs. bond correlations
Source: Bloomberg and Nikko Asset Management
In our view, we may just be about to enter another period where bonds and equities are highly correlated.
Bond yields are at such low levels that the risk-return profile is asymmetric. Continuation of ultra-accommodative unorthodox monetary policies can keep yields anchored at very low levels for a very long period of time. But they cannot push them much lower across most developed markets. Recent comments from central bankers, including Mark Carney and Janet Yellen, suggest an increasing reluctance to consider negative rates as a policy option. The Bank of Japan too is investigating the effects of its NIRP and the hurdle is high for it to drop rates any further into negative territory.
On the other hand, inflationary risks are on the rise, most notably in the US but also perhaps in the rest of the world. The deflationary impact of falling commodity prices has started to ease as commodity prices start to stabilise, while easier fiscal policies are likely to aid consumption.
At the same, time investor demand for negative yielding bonds has become more fickle and unpredictable as highlighted by the recent poor demand at Japanese government bond (JGB) auctions. This may have been the primary driver behind the spike in 10-year JGB yields from around -30 bps to zero. Bund yields witnessed a similar spike in April 2015. Continued central bank buying of bonds is not unlike large pumps draining the available supply of bonds from a pool. However, the response of other market participants is important too, even though their relative importance may have diminished. Any change in investor attitudes or an unexpected inflation shock could lead to a sharp and disorderly sell-off in bonds at the very same time that equities are selling off.
In this scenario, the positive correlation could come to haunt all multi-asset strategies.
Protecting portfolio downside in multi-asset strategies
If sovereign bonds do not provide the safety buffer that they once did, how can we best position multi-asset portfolios to mitigate downside risk? We believe the answer is to do the following:
- Select assets with at least some valuation cushion since they are likely to fall by a lower magnitude;
- Avoid negative rates so the asymmetry is not as stark; and
- Invest in some cheap inflation assets like infrastructure, inflation-linked bonds and perhaps gold.
Outright purchase of downside risk protection is another useful option if one is prepared to pay out some premium. The cost of protection can be considerably lowered (by as much as 60–70%) through exotic option strategies such as equity put options contingent on higher bond yields, or a best-of-put structure on equities and bonds. In our view, relative value positions, such as long positions in stocks that benefit from reflation (e.g. banks), paired with shorts in bond proxies like utilities or low volatility stocks could be similarly useful.