Will bonds be ballast as rates rise?: James Saft

September 16, 2015

Sept 16 (Reuters) – Remember all that stuff about
diversifying into bonds so you don’t get hurt too badly during
the bad times?

Well now that we face a likely cycle of interest rate rises,
that argument for diversifying into government debt may not hold
water.

The Federal Reserve decides on Thursday whether to hike, but
most observers expect that we are on the cusp of a tightening
cycle, though one with a lower ceiling and lower velocity.

The quandary for investors is that bonds may not do what we
expect them to as part of a portfolio when rates rise: contain
volatility and contribute sufficient yield to soften other
blows.

Investors don’t diversify into government bonds because they
think they will outperform riskier assets, they do so because
holding bonds acts as a stabilizer on their portfolios.

That allows investors to carry more equity and other
asset-class risk than they otherwise would, because bonds,
though plodding and given to lose value when rates rise, are
less subject to vicious losses than stocks or commodities.

This time round, though, we start with bond yields at very
low levels and with a bond market that’s changed its dynamics.

Those low yields, depending on your beliefs, are because of
low growth or because of artificial demand from central banks.

But central bank demand may be waning as emerging market
central banks, notably China’s, sell Treasuries to fund the
fight to keep their own currencies stable.

That’s even before we consider the possibility that the Fed
itself might allow its $4 trillion balance sheet to shrink,
something that seems a long way off.

As well, the structure of the financial markets has changed,
with banks being less willing to hold bonds in inventory because
that inventory is penalized under new safety regulations. That
may imply higher volatility in government bond markets.

In other words, what investors thought was ballast, keeping
their portfolios steady, may instead be panicky passengers,
running from one side of the ship to the other and accentuating
the impact of outside forces. By some measures, Treasury market
volatility is up about 18 percent in less than a year, an
indication of uncertainty about monetary policy and the economy
and, perhaps, a structurally more volatile market.

STICKING WITH IT

Barclays Capital looked at the behavior of major asset
classes during past 10-percent-plus selloffs in global equities
and compared it to how they fared in August. Thus far the
results were fairly typical: bonds tend to rally during
sell-offs then give much of that back when equity markets
stabilize.

In other words, expect a bit of diversification benefit if
markets get upset when the Fed hikes, although this will be a
diminishing effect.

“To the extent that markets start to price in the start of a
tightening regime in the months to come, bond returns will be
less likely to be positive. As such, multi-asset investors
should expect smaller diversification benefits from bond
allocations in balanced portfolios,” Guillermo Felices and Simon
Polbennikov write in a note to clients.

None of this is to say that anyone expected bonds to be the
stars of their portfolio during a rate-rise cycle. History is
clear: they underperform equities and with slightly higher
volatility than normal, though lower volatility than equities.

What is of concern is the potential scope of losses,
especially at the long end of the interest rate curve, where
small moves in rates will extract maximum damage. If we get
that, and higher volatility due to changes in market structure,
or unexpected sales by central banks, then government debt may
underperform its historic track record during similar periods.

And there have been some difficult periods.

Patrick Beaudan, chief executive of financial advisory firm
Belvedere Advisors, points out that had you built in 1962 a
simple 60/40 portfolio of the S&P 500 and 20-year Treasuries you
would have had to wait until 1982 until you finally showed a
gain that never broke again below your starting point.

To be sure, a simple two-asset portfolio is rarely desirable
and during that period, which included some terrible years for
stocks, bonds would have often smoothed volatility as
advertised.

You could of course eschew government debt altogether,
looking elsewhere for diversification. That presumes
foreknowledge, which most of us lack. Few would have predicted
the performance of the bond market in getting us here, much less
the long periods of outperformance with lower volatility that
bonds have offered during the last 30 years.

If you want less volatility, but don’t feel you are being
compensated for taking the risk of holding bonds with longer
maturities, you could always buy shorter-dated ones which will
be hurt less by interest rate movements.

The truth is that we’ve never been through a cycle like the
one we are about to enter. That argues for caution rather than
big bets.
(At the time of publication James Saft did not own any
direct investments in securities mentioned in this article. He
may be an owner indirectly as an investor in a fund. You can
email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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