Bonds have long been a staple of multi-asset investing, a harbour where managers could moor client money safe from the ebbs and flows of more volatile equity markets.
However, the growing prospect of an outstretched bear market in bonds brings what has been traditionally a 30-70% weighting in multi-asset funds into question.
‘Investors who follow the old adage that bond weighting in a portfolio should match your age may find themselves in a difficult place, particularly if they are approaching retirement,’ said Markus Stadlmann, chief investment officer of Lloyds Bank Private Banking.
Going forward, as a means of capital preservation bonds are not looking like they will live up to their reputation.
‘US markets have been rocked by bond yields and corporate earning concerns. This rattled investor sentiment has now rippled across the global markets,’ said Tom Elliott, deVere Group’s international investment strategist.
Despite Elliott seeing this current global sell-off as unlikely to be the beginning of a bear market, more bearish investors like Stadlmann do not agree.
With central banks now beginning to unwind nearly a decade of monetary policies, and reducing the volume of bonds they hold, Stadlmann thinks we will see some of the market's biggest buyers slow and start to move to the sell side.
‘This will both undercut the demand and boost the supply, majorly tipping the scales towards a downturn in prices. As a second order effect, debt servicing costs and national budgets will be impacted by any increase in interest rates. Higher rates will result in greater costs to service the £164 trillion of outstanding global debt.’
Therefore, if the bond bears are indeed correct, the obvious question that remains is what will or can take the place of bonds in a multi-asset portfolio.
For Stadlmann absolute return funds can be the new conservative anchor in diversified portfolios and he expects them to generate a higher positive absolute return than investment grade and high yield bonds.
‘These funds will typically move counter to many traditional asset classes,’ he explained.
‘They utilise financial models and computer-driven decision-making processes that achieve solid investment performance whichever way financial markets move – be it a bull or bear market. These funds aim to make our portfolios more robust, and continue to generate positive absolute returns even during adverse financial market conditions.’
Stadlmann is not alone in this. Multi-asset manager Apollo highlighted in its quarterly outlook that its Athena discretionary portfolio’s exposure to absolute return funds continues to deliver strong, uncorrelated returns.
The firm singled out Old Mutual’s Global Equity fund—run by AA-rated Ian Heslop, Mike Servent and Amadeo Alentorn—as a strong performer gaining almost 3% over the quarter despite the sharp equity markets set back.
‘The recent surge in interest rate expectations means that we were correct to avoid broad exposure to the bond market and remain focused on specific areas of the bond market, such as short duration high yield where there is little sensitivity to interest rate changes,’ the report stated.
In light of the perceived struggles with bonds, Stadlmann has been gradually shifting his clients' portfolios further away from bonds and into absolute return, where he sees better risk-reward over the long term.
Nick Peters, portfolio manager in Fidelity's multi-asset team, on the other hand, sees a direct swap of bonds for absolute return as reductive.
'Absolute return funds are not necessarily an alternative to fixed income, and treating them as such would be an over-simplification,' said Peters.
He currently holds the Majedie Tortoise fund, a long/short equity strategy, which has a notably bearish positioning and serves as a hedge.
'Interestingly, given its short positions in expensive bond-proxy stocks and its long positions in inflation-sensitive cheap stocks, we actually expect this holding to move in the opposite direction to bonds under certain conditions - for example, in a scenario of runaway inflation.
Peters pointed out the volatility of Majedie Tortoise also means the risk of this fund is actually meaningfully higher than that of most government bond benchmarks. Admittedly, he thinks its return potential is closer to that of equities than bonds over the medium term.
'In summary, we're not using absolute return funds as a replacement for government bonds, but we assess them on a case by case basis.'