Safe haven bonds in an inflationary environment

Iain Ramsey, Chief Investment Officer, AHR Private Wealth

Safe haven bonds in an inflationary environment

In the current climate, the merits of holding traditional ‘safe haven’ bonds seem few and far between. Increasing but albeit still relatively low yields, alongside recent volatility similar to equity markets make the trade a very difficult one and has investors questioning their traditional investment approach and asset allocation.

When also factoring in the spread between bond yields and equity earnings yields, the trade looks even less compelling. However, what is important for investors to consider is what are the main drivers of including these safe haven assets in the first place? Often their inclusion is done so to add protection against equity market volatility and to ensure that at times of market stress the whole portfolio is not correlated to equity markets. Of course, on top of this, there is the steady flow of income these assets can provide (although despite recent moves this still looks relatively unappealing).

High inflation and rising interest rates have created an ideal scenario for traditional asset class holders enabling both their equity and fixed-income holdings to sell. As both equity and fixed income holdings are being sold off at the same time, the reasoning as to why points to the duration of these assets. and higher inflation are worth less to an investor today due to the uncertainty of the market and growth equities have been sold off the most as a result of their price being based on their predicted future cash flows. Additionally, the income provided by government bonds is also worth less to investors today.

Understanding this dynamic gives investors insight as to why their traditional asset approach may currently be struggling and the prompt to consider what action they should take. Certainly, it would be neglectful to ignore this dynamic and maintain the traditional approach on the premise it has worked previously.

Relying on safe haven assets in market uncertainty

Safe haven bonds remain an attractive asset during market shocks caused by conflict, the pandemic or recession as they tend to stay relatively consistent and are affected by event with a delay. In recent times of world distress, such as the initial outbreak of Covid 19 and the onset of war in Ukraine, it took longer for safe haven bonds to show the effects of inflation. With this in mind, investors should be considerate when holding safe haven bonds and not act in the same way as they might have done before but consider allocating them as a more reliable bond in market shocks.

However, one of the biggest hurdles to this flexibility across asset allocation has been and is, the use of passive investment vehicles and their advocation of traditional asset splits between traditional equity and traditional fixed income.

Many investors will find themselves with a split of low-cost equity ETFs and low-cost Fixed Income ETFs. This approach has worked well and may continue to do so over the longer term, however it is important for investors to understand what they own, in particular within the fixed income space. In a traditional global equity ETF, the vehicle will buy shares weighted to the market capitalisation of the companies within its index. Over the long term this should lead to the vehicle buying more

of those companies that have performed best and grown accordingly. This is not always the case in the short term, but longer term this should stand true.

But most Fixed Income ETFs simply buy the largest issues of debt within its respective index with no consideration of quality or duration of the issues, just simply which company or Government has issued the most debt. It soon becomes apparent that this is a very different dynamic to that of an equity equivalent and presents risks to investors of these ‘cheap’ vehicles that they may not be aware of. This process works well when these assets are lowly correlated to equities and provide a favourable level of income, but when they sell off in a similar vein to equities, Bloomberg Barclays Agg -4.66% YTD (at the time of writing), this ‘cheap’ approach may need to be revisited or, at the very least, truly understood by the investors led to believe that this is a surefire, safety-first approach.

So what is the correct approach to asset allocation in this environment?

Finding the right approach

While an allocation to safe haven bonds is still warranted, this will be on a lower one than the historic norm and the challenge then lies with investors to maintain the desired risk profile.

But in order to escape an inflationary environment unscathed, utilising alternative asset classes and areas of equity that are typically able to perform well in this environment can prove useful. The risk of property and commodities such as gold and silver being as volatile as equity is often much lower for example because these assets are not typically the ones hit the hardest in an inflationary environment. Which makes them a good equity alternative.

There are also only a few absolute return strategies available to mirror the return profiles of safe haven bonds. This are for example consistent low single digit returns with low single digit volatility through both long and short equities or accessed by using derivatives to take advantage of currency changes or interest rate rises. However, even those are perhaps riskier as there remain many absolute return strategies that are closet equity trackers, and where precision in selection remains a key factor.

Creating a barbell portfolio

In this instance, bond yields and equity are scattered at some of the highest level in decades. And whilst higher risk is usually entailed, equities currently have a much prospect in terms of risk adjusted trade than bonds. As such, it is based on this metric that investors should adopt a barbell approach to investing whereby they can take a higher equity allocation while continuing to invest their fixed income into the lowest risk investments that act purely to preserve the real value of their holdings. This can enable them to retain the benefits produced by favourable equity trade relative to bonds and keep the same risk allocation. As mentioned above, selection remains key in any case and precision in to choose equity and fixed income is crucial.