- High prices and low current yields make government bonds less attractive.
- Yet effective risk diversification remains one of the key topics for investors.
- While high-quality corporate bonds, gold and real estate have different risk profiles than government bonds, they can still serve as alternatives.
was the increase in the gold price in the first half of 2020 in U.S. dollars, making this precious metal the absolute winner amongst key asset classes according to the World Gold Council.
Source: World Gold Council
Among investors it was considered an iron law: If equity prices fall, then government bond prices are most likely to rise. Experts refer to this as a negative correlation. In particular, high-quality government bonds traditionally perform two functions in a portfolio: on the one hand, they provided predictable returns; on the other, they offered a reasonable prospect of a compensatory performance effect during stress phases on the equity markets.
The backdrop to this long-enduring mechanism is that equity market prices mostly fall whenever recessions loom. At the same time, as a rule the central banks lowered their key interest rates in such phases, causing government bond prices to rise. However, this no longer applies in the age of low interest rates; policy rates are already close to zero. Moreover, government bonds hardly offer any yield at all, with numerous debt securities trading at yields below zero. Investors therefore need to look for alternatives.
Effective diversification still remains key for investors
Investor who diversify their portfolio holdings can effectively reduce the individual risks of a financial investment. The academic groundwork for the concept of clever diversification was introduced by U.S. economics professor Harry M. Markowitz as early as 1952 – in 1990 he was awarded the Nobel prize for economics. According to modern portfolio theory based on Markowitz, risks can be balanced with particular effectiveness if the spreading of risk – referred to by the experts as diversification – takes place across various investment classes that tend to move in opposite directions.
However, the approach established by Markowitz in connection with government bonds at present no longer seems to work. The negative correlation of equities and fixed income securities has declined or has even been reversed in the most recent equity market turmoil. In parallel with equity markets, at times the bond markets likewise produced negative returns.
A look at the details is worthwhile to acquire a better understanding of the situation on the bond markets. For one thing, prices of bonds with good ratings have risen to such levels that they trade at negative yields-to-maturity. In large areas of Europe, this even applies to long-term government bonds. Another factor is that the bond purchasing program of the U.S. Federal Reserve and the European Central Bank (ECB) caused market distortions after bond trading had practically come to a halt at times during the corona panic. This panic also led to numerous institutional investors in search of liquidity actually dumping entire asset classes, causing the correlations previously observed to be eliminated.
Diversification potential of government bonds has declined
Interest rates will probably not move higher for a long time to come. The low level of interest rates is likely to continue producing extremely low returns especially for high-quality government bonds – in turn providing less diversification potential. Consequently, investors need alternative elements to spread risks. The dilemma is that it is not an option (especially for portfolios focusing on relatively safe investments) to simply lower the government bond allocation in favour of higher-yielding but far more volatile equities and high-yield debt securities. And it is also becoming clear that in view of the complexity of the subject for private investors, it is probably sensible not to take matters into their own hands but to rely on the expertise of capital market experts.
Potential solutions for successful diversification
What can potential solutions look like specifically? Good opportunities for risk diversification and for additional return potential can be found in selected corporate bonds and gold investments – both being options with low correlation to equities. For instance, Klaus Kaldemorgen most recently focused more intensely on corporate bonds in the DWS Concept Kaldemorgen multi-asset fund he manages, while reducing the government bond allocation in return. The fund portfolio also contains investments in gold.
Conclusion: Classic portfolio theory tends to reach its limits especially in phases of substantial market distortions, making flexibility a key factor. For portfolio risk management purposes, investors need to consider alternative investment choices, especially to low-yielding government bonds.
Flexible, broadly positioned multi-asset funds which invest in multiple asset classes are best suited to deliver this shift. Investors who prefer to diversify even further could, in addition to multi-asset funds, also look to open-ended real estate funds.
Even if multi-asset funds like the DWS Concept Kaldemorgen are broadly positioned across various asset classes, these funds are likewise subject to the typical risks of capital investments: elevated price risks in equities, fixed-income and currencies as well as credit quality risks that may lead to possible capital losses. The situation is similar for open-ended real estate funds. They likewise reflect moderate equity, interest rate and currency as well as credit quality risks.
Ultimately, the opportunity to achieve higher potential returns always also entails increased risks. This is why it is essential to finely balance investment portfolios.