What do bonds actually do in your portfolio?

Bonds are a greatly unloved asset class, yet they have their attractions. Here we explore the kind of losses investors could face as yields rise and investigate whether they still offer diversification benefits.

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What do bonds do in your portfolio?

After a bull market that’s lasted for 25 years, some investors now plan to sell all their bond holdings because they fear that rising interest rates will see bonds record large losses. Others argue that the end of quantitative easing (QE) will mean that bonds lose their diversification properties; thus falling bond markets may go hand in hand with falling equity markets.

For those interested in asset allocation, these concerns are worth looking at in a bit more detail.

What impact could rising yields have on bond prices?

The 10-year UK Government bond currently yields 1.44% and has a sensitivity to interest rates (a ‘modified duration’) of approximately eight years. This means that if the bond’s yield rises by 1% overnight, the price of the bond should fall by 8%.

There are two things to remember here.

Firstly, the bond pays a regular coupon, which can be re-invested at higher rates. If the 1% yield increase happened over a year, the loss on a total return basis would be more like -6.5%.

Secondly, most private client portfolios won’t have a sensitivity to interest rates of anything like eight years. For example, within IG Smart Portfolios, the moderate portfolio’s fixed income sleeve (66% of the portfolio) has a sensitivity to interest rates of 4.2 years, resulting in an overall portfolio interest rate sensitivity of 2.8 years. Investors will suffer some losses if interest rates rise, but these could be largely offset by gains in equities, as rising interest rates are usually perceived as a sign of economic strength. 

It is worth noting too that IG Smart Portfolios are currently positioned for rising interest rates. When the opportunity arises, the medium-term goal is to re-invest the less sensitive short-dated bonds in the portfolio back into bonds with a higher return profile.

Are bonds losing their portfolio diversification benefits?

Of more concern to a portfolio manager is whether bonds may be losing their diversification benefits. In an ideal scenario you could hold equities and another asset to which equities were perfectly negatively correlated. Therefore, if equities fell in value, the negatively correlated asset would go up in value. Over the past 30 years, bonds have done this job very well.

With QE coming to an end, what will happen to correlations? If the doomsayers are correct, the removal of a natural buyer will see yields rise, which could lead to bonds and equities falling in value at the same time.

To investigate this, we needed to test whether the introduction of QE in December 2008 had made a large difference to equity-bond cross correlations. In the chart below, we can see the rolling 12-month correlation of UK gilts to global equities, with the average correlation showing a small move upwards from when QE was introduced in December 2008.

Chart 1: rolling correlations of UK Gilts to Global Equities

Source: Bloomberg, IG, March 2018

Nevertheless, it is evident that in the past two years correlations have been a bit higher, breaking into positive territory. This may be because equity market volatility has been very subdued relative to recent years, or it could be that the dynamics driving bond markets have fundamentally changed.

Until there is further evidence, we just don’t know for certain. What we do know from looking at the other available asset classes, is that bonds still offer the best diversification properties relative to equities and can help smooth your investment returns while providing some portfolio insurance in a deflationary environment. Purely from a returns perspective, bond markets should fall considerably less than equity markets in a risk-off scenario. 

Looking at correlations over the past two years, UK gilts have had a correlation of 0.13 to global equities, while gold has a correlation of 0.27. To put this into perspective, UK equities have a correlation to global equities of 0.79.

Changing market dynamics mean that correlations between the asset classes change throughout the economic cycle. For now at least, bonds are still the best diversifier out there.

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