Tempted to forego your exposure to government bonds? Make sure you understand the risks to your portfolio.

Steve Williams from Cormorant Capital Strategies outlines why government bonds still have an important role to play in your portfolio.

How diversified is your portfolio? If you were tempted to forego exposure to government bonds, I would argue that you are in danger of reducing your portfolio’s diversification to dangerously meaningless levels.

With yields close to 2%, both at home and abroad, the press is awash with comments about ‘new territory’ and an inevitable collapse in bond prices. I’m unsettled by some of the lazy analysis I have seen in this regard because it encourages investors to replace government bonds with corporate bonds, absolute return funds or increased equity investment in a misguided attempt to reduce risks. Ordinarily, such a shift would be intuitively wrong, but against today’s narrative such moves are somehow accepted as common sense.

In my view, the motives for these shifts are riddled with inconsistencies and are increasingly vulnerable to the risk of poor forecasting. Never mind the seemingly odd logic which suggests that simply because asset A is ‘unattractive’ asset B is automatically ‘attractive’. What is most damaging is the notion that a wholesale shift from government bonds can be exercised without reducing diversification.

Diversification is, nowadays, linked with that tired cliché – something about eggs and a basket – and its perceived benefits are used to underwrite investor demand for increasingly exotic funds.

Considered diversification is about so much more. At the heart of a genuine attempt to diversify is a drive to reduce unnecessary risks; that requires a deeper understanding of the interplay between the broad asset classes as we move from one economic condition to the next.

It is in the nature of the economy, and other aspects of aggregate human behaviour, that such conditions are very difficult to forecast accurately. With all of the research capability at the Bank of England, the Treasury, the Office for Budget Responsibility and myriad private forecasting institutions, we still cannot describe how the UK economy will look later this year, let alone ten- or twenty-years hence.

Our starting point then, must be for the inclusion of assets that we can expect to perform well in one, or more, of the following four economic conditions: (1) high growth / low inflation, (2) high inflation / low growth, (3) high growth / high inflation, (4) low growth / low inflation or disinflation. Added to these somewhat simplified templates we can expect periods of spontaneous panic (I count five stock market panics in just the last fifteen years) so some exposure to assets that perform well during times of crisis would be a boon.

Conventional domestic government bonds (gilts) perform well in two of the four conditions (1 and 4) and have the added benefit of being increasingly attractive in times of stock market panic. Index-linked gilts and overseas government bonds perform well in periods with higher domestic inflation with mixed performance in times of panic.

In foregoing exposure to government bonds, investors are shaping their portfolio for just two of the four potential economic environments highlighted above. In these instances, corporate bonds are not a substitute for government bonds since they share some equity-like properties (think lower corporate earnings amounting to higher bond defaults). What is more, investors are increasing their portfolio’s sensitivity to falls during times of panic. Given investors’ propensity to sell out of falling markets, this latter tendency is far more damaging in the long-run than one might think.

I’m not such a contrarian as to suggest that returns from government bonds will be terrific in the forward period. That is not my message. Reduced exposure to government bonds may or may not be appropriate for some investors – such issues of individual suitability, as an aside, are what makes a good IFA so valuable. But if investors, starting with a diversified portfolio, are to reduce government bond exposure they must do so in the full knowledge that in the long-run they are increasing risks, not reducing them.

If you wish to discuss financial planning or investment planning, please telephone 020 3865 2379

 

 

 

 

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