Nervous markets are a reminder for us to check our investment strategy. If there was a fall like 2008, or even the smaller fall in China last month, how much would you lose and can you afford to take that big a loss? Over the past two weeks we have taken a lot of calls from clients wanting to talk about reviewing their overall portfolios to find somewhere safe to sit out this ongoing volatility
We set out four strategies below ranging from the current typical equities and cash “barbell” strategy; two diversified portfolios with bonds; and one in bonds and cash.
In highly volatile markets, investors are reminded of how just how fast equity markets can fall. The GFC in 2008 was not that long ago, and many people are still feeling nervous about the 43% fall in equities that year and whether we could see a repeat. The 26% fall in the Chinese market last week reminds us what happens when the fear cycle kicks in.
Over the long run, equities will outperform less volatile investments. But history tells us that the “long run” can be 10-20 years, as shown below. For the past 120 years, these cycles have been unpredictable ranging from nine to 22 years with near zero gains for equity markets. Each time the bear cycle has started when valuations have risen too far, as shown in the lower part of the illustration below. Whether we are at that point today doesn’t really matter, as we are certainly not at the low valuation points that have sparked the start of a bull run.
Time to look for a safe harbour, or to push through the storm?
Figure 1. Graph by Robert Shiller comparing the secular bull and bear markets from 1900 – 2014.
With this background in mind, it is worth revisiting why bonds are added to a portfolio, that is to reduce portfolio risk in the event of an equities market correction. To illustrate this, four portfolio strategies are compared below.
Four portfolio strategies - performance over the past 100 years*
Figure 2. A table combining various strategies for investment allocation.
*This analysis uses US data (S&P500, US Treasuries, sourced from Yale University) to get access to the longest time series of data available.
The observations from this are:
- No equities is a poor long term strategy
Strategy 4 offers a lower average return and the second lowest worst 10 year period return. Even more concerning is that this portfolio returns less than inflation in 25% of 10 year investment periods. - Switching 25% from equities to bonds halves worst year, but doesn’t reduce best and average returns by as much
Strategy 1 has the greatest average return, but also a worst year more than double that of Strategy 2 and Strategy 3.The question, which is a personal one, is whether the extra return is worth the downside risk. - Also then switching 15% from cash to bonds improves returns and reduces risk
Strategy 3 has better returns than Strategy 2 regardless of whether we look at best, average or worst year returns. It also has the lowest risk of failing to beat inflation. This portfolio shows the benefit of shifting cash allocations to bonds – a pick up in returns with a slight increase in risk.
Suggested portfolio - For those wanting to increase their allocation to low risk bonds
The most asked question is how to construct a portfolio to generate the income investors’ need, while keeping risks to a minimum. The starting point naturally has to be: it depends on your needs in terms of income and in terms of avoiding risk. But a generic framework that doesn’t take into account individuals’ needs can still be framed.
The following is a high quality portfolio that is designed to perform well in times of stress. It intentionally has a high allocation to fixed rate bonds (37%) and inflation linked bonds (51%) - including both capital indexed bonds and indexed annuity bonds, known as CIBs and IABs. These fixed and inflation linked bonds have ‘long duration’ or interest rate risk. In times of market stress when equities are falling, it is typical to see longer dated yields fall and prices rise to protect the overall portfolio return.
Many of the issuers are Australian infrastructure and essentially service entities, including public-private-partnerships (PPPs), which are removed from developments in China and Europe. There are a number of highly rated, very safe IABs that are often forgotten by investors that provide both strong returns and excellent cashflow.
Despite the high quality of the portfolio (average rating of very high A+) it still maintains a yield to maturity of over 5%.
Diversified high yield portfolio
Figure 3. Sample portfolio of high yield bonds, IAB is the acronym for Inflation Linked Bond and CIB is the acronym for Capital Indexed Bond.
Obviously this is just one possible ‘safe harbour’ portfolio and a number of tweaks could be included to match individual preferences, including:
- Increased allocation to government bonds, the true ‘flight to quality’ asset, although this would likely see the yield to maturity closer to 3%
- Inclusion of residential mortgage backed securities (RMBS) as alternatives to floating rate notes. AA- rated RMBS with a weighted average life of eight years are available with trading margins of circa +220bps and BBB rated options with a five years weighted average life trade around +300bps
- Those worried by the prospect of rising rates could increase floating rate options, although much of the countercyclical buffer/smoothing effect detailed in the analysis above is provided by the increased price in fixed rate bonds in times of stress
Next week, we will look at combining a high quality/investment grade portfolio with a diversified high yield portfolio and compare the overall risk and return metrics.