Investors with long dated liabilities such as defined benefit pension plans and insurance companies are familiar with the use of long government bonds to hedge their interest rate exposure. The most successful of these organizations, have followed a disciplined approach to progressively add to their liability-focused, fixed-income programs regardless of the level of interest rates.
The investors outside of defined-benefit pensions and insurance companies face a similar situation. The purpose of investing in capital markets for most investors is to have reliable fixed, and hopefully high, cash flows after retirement. That means that regardless of the composition of the portfolio that individuals are holding they are hoping to outperform their (fixed) long-dated liabilities in retirement.
The purpose of this article is to focus primarily on the role of long bonds in purely return seeking portfolios absent considerations for investor liabilities.
The problem with traditional return seeking balanced portfolios
The 60/40 equity-bond construct is the most common balanced, return seeking portfolio for investors. In Canada, the 60% equity portion is commonly benchmarked against the S&P/TSX Composite Index and the bond portion follows the FTSE/TMX Canadian Bond Universe Index (7.5 year duration). In the United States, the 60% is typically benchmarked against the S&P 500 Index and the bond portion against the Barclays US Aggregate Bond Index (5.5 year duration).
There has been a mountain of research since the Global Financial Crisis (GFC) that shows 60/40 balanced portfolio is a poor construct. These are some of the shortcomings of the 60/40 portfolio construct in the current environment:
- The 60/40 portfolio is dominated by equity risk. What this means is that given the higher risk of equities, 60/40 portfolio is not nearly balanced in risk terms.
- Inside fixed income, with the zero lower bond (ZLB) monetary policy in major economies, the short-end of the yield curve does not move sufficiently to offset equity volatility.
- The exposure to corporate credit and other spread products within both the FTSE/TMX Canada Universe Bond Index and Barclays US Aggregate Bond Index correlates positively with equites and takes away from diversification benefits of fixed income.
The last issue above, has become a more serious problem in recent years as investors have fallen into the so-called "yield fallacy" and have migrated more of their fixed income assets into higher-risk bonds, thus taking away from the primary function of fixed income: diversification.
The evidence against traditional 60/40 and popular fixed-income benchmarks
Table 1 depicts the volatility of 60% equities vs. 40% bonds for balanced portfolios using short, medium and long term history. The historical evidence supports the notion that the risk of a 60/40 balanced portfolio is heavily skewed to equities.
Table 1 – The 60/40 balanced portfolio is dominated by equity risk
Focusing on the fixed income side, both FTSE/TMX Universe Bond Index and Barclays US Aggregate Bond Index are relatively short duration. The response of short and medium rates to economic shocks is muted especially in the ZLB monetary policy environment as shown in Graph 1 below. The front-end of the yield curve does not respond to global deflationary shocks to the same extent that the back-end does.
Graph 1 – The efficacy of the front-end in mitigating deflationary shocks is limited
Another issue with popular fixed-income benchmarks is its heavy exposure to corporate credit and other spreads. Graph 2 shows the correlation and beta of the Barclays US Aggregate Bond Index as well as the US Long-Term Treasury Index to the S&P 500. Because of its shorter duration (5.5 years) and the fact that Barclays US Aggregate Bond Index is contaminated with spread risk, its negative correlation and beta to risky assets is relatively muted.
Graph 2 – Popular fixed-income benchmarks do not deliver much diversification
A truly balanced portfolio with long bonds
To bring balance and diversification back to most 60/40 balanced portfolios, investors must revisit their fixed income allocation design. This starts by defining the desired attributes of fixed income and designing the fixed income portion accordingly. Graph 3 shows how this can be done.
Graph 3 – Designing a fixed-income portfolio to satisfy investor needs
The pyramid on the left shows the desired attributes of the fixed income allocation. The pyramid on the right shows the fixed income instruments to achieve it. The size of the section shows the importance of each attribute.
For example, diversification is the primary attribute that fixed-income investors seek. This can be accomplished by investing in global developed market long bonds. In fact, long bonds (both nominal and inflation-linked bonds under certain economic environments) are the cheapest equity (or broader risky asset) hedge. It is important to note that this attribute of long bonds is valuable regardless of the prevailing level of interest rates. Developed market government bonds are also the primary source of liquidity.
Another desired attribute is income that can be achieved by investing in corporate bonds, emerging market sovereigns, mortgage backed securities, etc. These investments however, take away from the diversification benefits of fixed income and, by and large, are inefficient forms of risk premium for portfolios that have access to equities as the primary source of pro-cyclical risk. As such, allocation to risky bonds inside fixed income should always be a tactical decision, not a strategic one.
Inflation-linked bonds (ILBs) are the perfect instrument to hedge against unexpected inflation in bond markets. For Canadian investors interested in preserving their global purchasing power parity (PPP), global bonds with foreign currency exposure are the instrument of choice. Since the currency exposure is unhedged, investors maintain their purchasing power in the foreign currencies that global bonds are denominated in (for example, U.S. dollars).
Lastly, value-add or alpha in fixed income is generated in relative value (RV) trading inside each segment that the portfolio invests in: governments, corporates, mortgages, currencies, etc.
Signature's fixed-income solutions
Signature has launched two strategies to fit the optimal construction (based on Graph 3) and also meets the fixed income needs of our clients. The First Asset Long Duration Fixed Income (FLB) ETF invests in global developed market long bonds as it is designed to be the most effective risky asset diversifier for portfolios with exposure to risky assets (e.g. equities, high yield, etc.) FLB ETF is actively managed and invests in all developed market bond markets globally to generate value-add.
Our Signature Tactical Bond Pool, which was launched in early 2016, invests in all segments of the global fixed-income market (e.g. global corporates, emerging market debt, mortgages, etc.) tactically to generate respectable fixed-income returns in counter-cyclical fashion. The key is to be tactical in allocation to riskier segments of fixed income because portfolios that constantly have an allocation to risky bonds will suffer from positive correlation to equities and take away from the primary advantage of fixed income: diversification.
A more optimal construct for the 40% fixed income allocation in balanced mandates which are benchmarked against the FTSE/TMX Canadian Bond Universe is 20% long bonds and 20% tactical bonds.
Table 2 shows the characteristics of our fixed income offerings. These fixed income products are all negatively correlated to popular equity indexes. The challenge in fixed income is to generate respectable returns in counter-cyclical fashion.
Table 2 - Signature’s fixed income offerings