The momentum has gone. What should investors do about bonds in their portfolio?

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.

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.

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