A COLLECTION OF MEDIA CLIPPINGS
12 Multi-Asset Funds
risk
Key points
FINANCIAL ADVISER 21.03.13 FTAdviser.com/FA
Safe havens WILLIAM BEVERLEY
■ Equities are risk
assets that can provide capital growth through exposure to returns from economic growth. ■ While equities may look reasonably priced, by comparison bonds now look very overvalued, posing a potential risk to the portfolio. ■ In an era of currency debasement, rising inflation expectations, and still buoyant commodity demand, the possibility of sharply rising interest rates triggering a sell-off in bond markets is a very real scenario.
W
ith interest rates having fallen to historical lows and spreads ballooning, investors are well aware of the potential for a reversal in rates with significant drawdowns in bond markets, especially volatile, longdated bonds that hold out the promise of more yield. Yet in an investment environment that remains dominated by macro and political perspectives, systemic fears and consequent risk-on/risk-off allocations, government bonds continue to look very attractive both as a safe haven, hedging asset and also as a portfolio diversifier. These qualities (not to mention QE, ballooning government balance sheets and reduced supply) have helped maintain a downward trend in yields stretching back decades (Figure 1). It is worth remembering why bonds are so beneficial in a portfolio, especially an equity portfolio. Whereas equities are risk assets that can provide capital growth through exposure to returns from economic growth, government bonds are risk-free assets that through times of strife should provide a steady income stream and return of capital. This simple yet fundamental difference helps to explain the typical negative correlation of equity and bond returns. In fact, in recent years the majority of asset classes have exhibited positive correlation with equities, only serving to increase the lure of bonds as a portfolio diversifier.
Bond Allocation Checklist n Interest Rates: Rising rates mean bond prices fall, especially long-dated bonds. n Maturity: Longer dated bonds or portfolios are more volatile but total return should be greater in the longer term. n Duration: Consider expected impact of rate changes on bond price. n Yield Curve: Relative value of bonds depending on maturity, issuer and credit quality – for example, spreads and curve shape – also signals expectations of inflation and macro risk. n Inflation: Rising inflation erodes the value of coupon payments. n Liquidity: This is particularly relevant when investing in over-thecounter markets – for example, corporate bonds and some sovereigns.
n Currency Risk: An important factor when investing globally, especially with volatile local currency emerging market bonds. n Credit Risk: You need to have a good understanding of default probability to avoid the loss of capital. n Correlation: Not all bonds negatively correlate with equities; for example, some high yield bonds or emerging market bonds. n Volatility: Does a bond fund actually produce bond-like volatility; that is, lower than equities? n Tactical Allocation: The flexibility to invest globally or by sector as many current (government) bond yields are so low that investors are locking in negative real yield. n Income: If it is an income fund, has it produced the required income?
The ability of bonds to increase returns when blended into an equity portfolio is clear (Figure 2), and risk-adjusted returns also improve significantly. While equities may look reasonably priced, by comparison bonds now look very overvalued, posing a potential risk to the portfolio. With interest rates at historical lows and inflation above average, investors in bonds are also suffering negative real yield. So, are the safety and hedging benefits of bonds worth the price? Worse still there is a very real risk of a significant fall in bond prices, with yields at an historically unprecedented divergence from long term and moving averages, particularly for short dated bonds. Figure 1 also confirms the historically unusual spread between short and long dated bonds that are also likely to converge. In an era of currency debasement, ris-
ing inflation expectations, and still buoyant commodity demand, the possibility of sharply rising interest rates triggering a sell-off in bond markets is a very real scenario – one which could suddenly make bonds look much less like a safety asset. One response is to rotate out of longer dated bonds into shorter dated bonds, a kind of reverse “operation twist”, which also has the advantage of preserving overall exposure to bonds in the portfolio. Bonds with longer maturities typically offer higher and more stable yields but add greater duration risk to the portfolio, that is, a greater move in bond price from an equivalent change in interest rates. This greater volatility in price demonstrates the significant risk premium from holding long dated bonds in the form of greater long
Multi-Asset Funds 13
21.03.13 FINANCIAL ADVISER FTAdviser.com/FA
from volatility Figure 1: US Treasury yields (1977 to 2013) Spread (value right)
Two year (value left)
30 year (value left)
Linear two-year (value left)
15
37 32
10
27 22 17
5
12 0
1977
1987
1997
7
2007
2 -5
-3
Source: Iveagh, Bloomberg
“Unless you believe interest rates are going to rise on an exceptionally gentle glide path, it seems the powerful advantages to holding long dated bonds are likely to be outweighed by the prospect of significant drawdowns”
Figure 2: Equity/bond blended portfolios (Dec 1997 to Feb 2013) 2.6 2.4 2.2 2.0 1.8 1.6 1.4 1.2 1.0 0.8
Portfolio 1 (100% equities) Portfolio 2 (60% equities, 40% govt bonds) Portfolio 3 (60% equities, 40% short-dated bonds) Portfolio 4 (60% equities, 40% long-dated bonds)
1997
2004
2012
Source: Iveagh, Bloomberg
Figure 3: Long-term US Treasury yield curve vs current 8
February 2013 yield curve
Long-term yield curve
7 6 5 4 3 2
wide spread narrowing on the short end of the curve. In these scenarios, the greater total return of long dated bonds, and their enhanced hedging characteristics due to higher volatility,
30 y
y 20
15 y
0
Source: Iveagh, Bloomberg
10 y
1
5y
should be highly stable, but this is offset by the hint of positive returns in year two that are due to the rapid rise in short term yield offsetting any price decline. Unless you believe interest rates are going to rise on an exceptionally gentle glide path, it seems the powerful advantages to holding long dated bonds are likely to be outweighed by the prospect of significant drawdowns. However, we cannot rule out rates declining even further, holding steady for an extended period à la Japan, or even the current
3m 1y 2y 3y
term total return. So should an investor hold short dated bonds to minimise loss in case of a rate rise, or does the higher yield of longer dated bonds more than compensate for this risk? Consider the impact of interest rate increases on the shape of the yield curve and the resulting impact on prices. Over time the yield is often thought to converge on the long term average, a process known as mean reversion. Currently, the short term yield is much further from its long term averages than the long term yield (Figure 3). If mean reversion was to occur, the short term rate has a lot further to rise than the long term rate (also reflected in the wide spread that we saw in Figure 1 ) which might mean significant price falls in short term bonds. Assuming a scenario with 50 per cent mean reversion of yields, in year one we can estimate a total return of -6 per cent and -36 per cent in short and long dated bonds respectively, followed by 0.1 per cent and -26 per cent in year two. The large price decrease, due to the much higher duration of long dated bonds, heavily outweighs their higher yield pickup, leading to significant negative total return over two years. Similarly, the case in less dramatic scenarios, for example, were yields to revert 20 per cent with a corresponding rise in rates of just 1 per cent over a year –surely a cautious hypothesis. The point is that longer term yields – not just short term yields – are sufficiently off long term averages for mean reversion to have significant price impact. Even so, the 6 per cent decline in short dated bonds is also concerning, especially for an asset that
might well swing the argument. William Beverley is head of macroeconomic research of Iveagh What do you think? Email: fa.letters@ft.com
citywire.co.uk/wm 14 February 2013
A FLY ON THE WALL…
Iveagh: Investment environment ‘too good to be true’ in short run ANNABELLE WILLIAMS a.williams@citywire.co.uk
Wealth Manager was given exclusive access to Iveagh’s asset allocation meeting, where a debate around whether Wealth around whether to toraise raise risk risk in in the the Iveagh core Iveagh Wealth model portfolio dominated proceedings. model portfolio dominated proceedings. The portfolio is currently weighted to risk level five, with around 50% allocated to equities. Chief investment officer Chris Wyllie reignited a debate that had featured in the firm’s December meeting, over whether risk should be raised. ‘One thing people have commented on is the Vix being very low, which is not to be sniffed at,’ he said. ‘Very short-term volatility expectations have collapsed, but everyone knows we have got the next stage of the budget talks coming in the US in March.’ Wyllie, who chairs the investment meeting, prefers the team not to arrive having already reviewed the investment data. Instead, he oversees a screen-based meeting, where a large portion of the time is spent looking at the data and considering options. ‘I have been on a lot of these committees and there’s nothing wrong with putting out those packs, but people read them three days or so before and there’s a lot of assumed knowledge,’ he said. ‘What happens is people come into the room and they may or may not know it, but their position is already established.’ After reviewing the price of FTSE put options, the team agreed they would think about going long volatility through options over the next six weeks, arguing that the options are currently priced at relatively cheap levels. The portfolio currently has a 0.6% exposure to options and warrants. William Beverley, head of macroeconomic research, suggested the portfolio should be moved up to a higher risk benchmark, pointing out that several of the in indicators Iveagh’s process that several of the signals technical in Iveagh’s were already green.at green. process were at already The team applies a traffic light system to factors, such as leading economic indicators, valuation and technical analysis. ‘What would it take for us to go to a six, when you already have three or four traffic lights that are green?’ Beverley asked. Wyllie said: ‘In a normal world you’d wait for the markets to come off a few percent. It’s just some of those sentiment indicators that are a little bit worrying.’ Beverley agreed the investment environment is ‘too good to be true in the short term.’ ‘It’s been a jolly nice run,’ Wyllie added. ‘There’s certainly a risk in bonds at the moment,’ Beverley said, while the CIO added there is a risk of government bond yields rising.
CITYWIRE WEALTH MANAGER
Chris Wyllie: Sees no reason to up risk at the moment
Earlier in the year, the team trimmed overall bond exposure to 23.2% ‘just to have no more than we have to have for portfolio defence’. ‘We have taken government bond weightings down to 7.5% so we are 2% underweight there,’ Wyllie said, although the weighting is still classed as ‘adventurous’. ‘You need a good reason to hold anything less than an adventurous weighting in government bonds because you need something there just for portfolio protection – but I don’t want to have any more there than we have to,’ he explained. Given the mix of positive signals and uncertainty over sentiment, Wyllie said he did not see a reason to up risk at the moment. ‘I don’t think markets are getting carried away with themselves that much. I don’t feel under any pressure for us to put more risk in the profiles because I think we have got enough.’
Iveagh’s current asset allocation:
Equities 52% Bonds 23.2% Property 5.9% Absolute return 3.1% Commodities 3.1% Infrastructure 4.9% Volatility 5.1% Options and warrants 0.6% Gold 2.1%
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