The momentum has gone. What should investors do about bonds in their portfolio?
15. September 2022
- Portfolio management
- Institutional investors
- Asset managers
Bonds have proved indispensable for many institutional investors and their portfolios. However, the asset class has two problems. First, yields are even now at low levels. Second, risks are increasing in the bond market. An intelligent overlay approach could help improve returns and reduce risk.
A few interruptions aside, the last three decades have been characterised by falling interest rates. For example, interest rates on 10-year German government bonds have dropped steadily in the period to as low as -0.85 percent from more than eight percent. Investors were in a comfortable position: the higher the portfolio’s duration, the greater the reward for the capital invested. Occasional brief increases in interest rates sparked some price losses but these were usually quickly offset by relatively attractive bond yields.
We have now reached a turning point. Several years of near-negative interest rates are behind us. In the meantime, complaints about low bond yields (see chart 1) featured in every conversation with institutional investors who are dependent on this liquid asset class for regulatory or diversification purposes. Yet investors should also not lose sight of their risk exposure.
After a decline in interest rates over the past three decades, bonds nowadays provide almost no risk buffer when yields are low.
Exceptionally low risk buffer for bonds
"The bond debate cannot focus on yields alone. The trend on the risk side over the last 15 years is just as crucial," notes Glenn Marci, Senior Portfolio Manager Overlay & Quant Models at Universal Investment Luxembourg. He backs up this view with data. In January 2006, a one-percent rise in interest rates led to a price increase of about 5.1 percent in the Bloomberg Barclays US Treasury Index. The equivalent interest-rate hike in January 2022 would have caused a price loss of about 7.1 percent. The problem is not just limited to US and US government bonds either. The same trend can also be seen to a similar extent in Europe, affecting government and corporate bonds alike. In 2007, before the financial crisis, an average 70-basis-point rise in interest rates could still be offset by European bond indices through the yield on offer at the time. In the years following the financial crisis, it has become increasingly difficult to compensate for these increases. As of the beginning of January 2022, yields have only managed to cover 12 basis points on average (see chart 3).
Several factors could currently trigger a further rise in interest rates. A rise in asset disposals by central banks would, for example, lead to a rise in supply and push yields up. Persistently high inflation could also force central banks to increase headline interest rates even further. “Today’s investors need to pay special attention to managing risk. In the current highly complex environment, different triggers or a combination of factors could lead to an increase in interest-rate risk and exert enormous pressure on bond prices in a portfolio", explains Peter Flöck, Head of Product Management (Portfolio Management) at Universal Investment Luxembourg.
Limited options for investors
There a very few ways to reduce the negative effects of rising interest rates in a portfolio with a benchmark-oriented asset allocation. Two approaches perhaps spring to mind but they still fail to solve the challenges investors face:
1. Significantly reduce bond positions in the portfolio
Although this lowers interest-rate risks, regulatory requirements tend to stand in the way of this strategy. Furthermore, as this typically increases the investor's overall risk exposure, they need to have a higher risk-bearing capacity,
2. Reduce the maturity of bonds in the portfolio
This strategy is particularly painful in a low interest-rate environment, as the already meagre returns received are reduced still further. From a risk perspective, an important counterweight to equity investments is also reduced, which results in a suboptimal allocation.
Investors who are dependent on bonds must therefore seek new solutions to improve the expected returns on their bond investments and also reduce risk.
We’re aware that bonds are essential for many of our clients. This is why we’ve developed targeted overlay solutions.
Overlay management creates new opportunities
Several questions still need to be addressed. How can intelligent overlay management help investors against this initial backdrop? How can they invest in bonds and nevertheless expect improved returns when faced with low risk budgets and tight regulatory requirements? How can overlay management help bonds to continue making an effective contribution to the diversification of an overall portfolio? "Put simply, we create an asymmetric return structure through the overlay. We aim to hold on to as many of the gains in the basic bond portfolio as possible. Losses should be reduced comparatively by cutting back investment levels in periods of rising interest rates," Glenn Marci explains.
Marci says that detailed analysis of the bond markets is a prerequisite for this strategy’s success. He and his colleagues focus on scenarios of stagnating or rising interest rates based on the respective challenges bond investors face. The case studies show that, depending on the initial situation, a risk management overlay can reduce the maximum drawdown on a bond portfolio by more than a third while also increasing the average total return. The volatility of the portfolio with a risk management overlay is about 20 percent lower compared with a portfolio without a risk management overlay. In addition to improving returns and reducing risk, it is also possible to include value floors while managing the overlay.
Peter Flöck says this result demonstrates exactly why such risk provisioning is more important than ever in the current investment environment for many institutional portfolios with bond exposure: "The risk management overlay was able to reduce tail risks in the low interest rate environment in the case studies and to significantly increase risk-adjusted performance."
Bonds still crucial for many portfolios
Bonds still form the core of many institutional investors' portfolios. Indeed, they account for 40 percent of the special fund portfolios managed by Universal Investment. As of September 30, 2021, a total of 195 billion euros was invested in bonds - more than in any other single asset class. Overlay solutions for bonds can therefore contribute to saving the Sharpe ratio in many portfolios.
Challenges and solutions for bond investors
Chart 1: Expected annual yields for various bond indices over a 16-year period. The expected yield comprises the average yield-to-worst and the roll down return. The expected yield is shown for the year at the end of which the estimate for the next year was calculated. For example, all data for 2021 were included at the last data point and formed the estimate for 2022.
Chart 2: The table shows the forecast duration-implied volatility (index risk) and the ratio of the estimated yield and index risk (yield/risk) for several bond indices and points in time. The average duration of the relevant year was used for the calculation. The volatility of the yield-to-worst (YTW) was calculated on the basis of daily yield changes using an expanding window as of January 1, 2005. Average YTW and roll down returns for the relevant year were used to calculate the expected yield.
Chart 3: Increased interest rates of various bond indices that were compensated over time. The chart shows how far interest rates in the relevant index were able to rise until the resulting price losses exceeded the expected return. The ratio is shown for the year at the end of which a hypothetical investment was made for the following year.
Chart 4: Performance of the interest-rate and duration-adjusted Bloomberg Barclays Euro Aggregate Treasury Total Return Index with and without a risk overlay in the period from July 1, 2005 to June 30, 2008. The performance of the BB Euro Treasury yield was adjusted to the yield and duration at the initial level on December 31, 2021. An ideal hedge quality was assumed. The red line indicates the lower limit below which the portfolio value was not allowed to fall. As soon as the portfolio value approached the lower limit, a hedge was set up successively against further price losses. The hedge was unwound either through price gains or in a situation close to a full hedge after three months.