Volatility has returned to the market disrupting the upward trend of higher share prices, so what does this mean for bond portfolios?
Background
The surge in volatility over the past week has brought a stop to the upward trend of higher share prices, which we felt had been toppy for some time.
The sharp correction in equities over this period has been enough to make investors stop and reassess portfolio allocation strategies. Ultimately, there comes a point when growth assets, and their token large swings in asset prices, gives pause for thought.
After the longest period of an equity bull market, we are likely seeing the beginning of the end of the cycle.
Volatility back in the markets
Also known as the fear gauge, the VIX Index, which measures equity market volatility surged last week, to levels greater than any point throughout 2019, as market participants grappled with the potential impact on the real economy of the fallout from COVID-19 led supply chain disruptions.
How have bond and equity markets reacted?
In a number of our prior publications, we continued to note that we expected volatility to rise, this assumption was based on susceptibility of markets being unable to handle geopolitical uncertainty and exogenous shocks, COVID-19 falls in the latter of these two categories. The fact that this economic cycle was ‘long in the tooth’ has been flagged by Government bond yields for over a year.
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Both Australian and US government bond yields have been testing historical low levels, reflecting flight to safety. The dislocation between bond markets and equity markets was evident throughout 2019, where both government bond and equity markets were rallying, this decoupling has been corrected over the past week as bond prices continued to rise while equity markets fell.
This movement was also very much visible in high grade corporate bonds. The chart below shows the performance of CBA’s shares compared to a long dated, fixed coupon, senior unsecured bond maturing 2033. The bonds performed the way they are supposed to, given their seniority in CBA’s capital structure, by surging higher while CBA shares fell.
So what does this mean for a bond portfolio?
It is always important to view individual bond holdings in the context of a broader portfolio. Portfolios with a healthy allocation to investment grade (IG) bonds would have experienced strong performance from the bond price rally over the past week as IG bonds are not as heavily impacted by credit spread moves as high yield (HY) bonds. Therefore, while IG bonds have lower coupons than HY bonds, these bonds also have lower volatility and offer more downside protection in a correction scenario.
However, if as an investor, you feel comfortable with the individual credit you are exposed to, then you should also be comfortable looking through any capital price movement. The reason for this is that unlike discretionary dividends paid on shares, the coupon payment of a bond is a contractual agreement that a company has to uphold. Furthermore, unlike equities, bonds have a specific repayment date when the issuer has to repay full principal back to bondholders.
As such, security selection and diversification are two key factors to keep in mind when constructing a bond portfolio. Please refer to our model portfolios below for suggestions on how to construct a portfolio.
Links
FIIG Strategy - Model Portfolios