Bonds and ballast: testing the limits

The resumption of central bank easing and the plunge of bond yields to historic lows earlier this year amount to a paradigm shift that is challenging the role of some government bonds in strategic asset allocations (SAAs). Expectations that interest rates would gradually rise as monetary policy normalised have been swiftly replaced by worries that interest rates in regions such as the euro area and Japan are hovering around what we perceive as their prevailing lower bound. The role of government bonds as portfolio ballast is particularly under pressure, in our view, in these regions. At the same time, our conviction in US Treasuries’ ability to provide ballast in risk-off episodes has increased. We believe this environment forces a rethink of the starting point for government bond allocations. China’s vast government bond market offers a strategic opportunity in this context. We introduce return expectations for Chinese assets in our capital market assumptions (CMAs) that allow us to incorporate them in our investor-specific SAAs.

Rethinking government bond allocations

The dramatic drop in government bond yields this year, taking nearly a third of global bonds into negative-yielding territory at one point, has raised serious questions about their role in a portfolio.

Low rates are not a new story. Yet the sharp about-turn on expectations that monetary policy was poised to normalise and set interest rates on a path higher challenges the role of government bonds as portfolio ballast where interest rates are near a perceived ELB, notably the euro area and Japan. At the same time, our conviction in our strategic overweight on higher-yielding US Treasuries has increased.

High risk, no income
Duration and volatility of 30-year government bonds, November 2019

Risks tied to how close interest rates are to their ELBs have important portfolio construction implications, particularly for holders of euro area government bonds where these risks are most acute, in our view. First, we believe the return contribution of bonds - via income or capital return - is very low. Second, the negative stock-bond correlation that underpins government bonds’ ballast properties starts to crack as policy rates – and by extension bond yields – approach their perceived ELBs.

Another potential consequence of negative government bond yields: An increase in zero-coupon bond issuance. This saps crucial income for pension and insurance funds. Bond mathematics also dictate that zero-coupon bonds would be longer duration than bonds with coupons and therefore exhibit equity-like volatility as the shaded area on the above shows. The sensitivity of the bond prices to changes in interest rates increases with duration.

Adapting to a low-yield world

The challenges brought by bond yields getting closer to their ELBs are serious enough to warrant a rethink of the neutral starting point, or benchmark, for government bond allocations. This is no trivial task because there is not a completely satisfactory approach, in our view.

A different starting point
Government bond allocations in our hypothetical unconstrained portfolio vs a market cap-weighted benchmark, 2019

We take a pragmatic approach of determining a government bond allocation that combines our expected returns with a recognition that some government bond markets, especially in the core euro area, may be closer to their perceived ELBs than other markets. We illustrate our work in the charts above. The chart on the left shows the government bond allocation within a multi-asset portfolio derived from a weighting based on market cap. The chart on the right shows the results of our approach. We are overweight government bonds in aggregate (see our unconstrained portfolio tilts on our CMA interactive website). Yet within that allocation, we recommend investors cut allocations to the euro area, hold more US Treasuries and make room for Chinese government bonds thanks to their potential returns and diversification benefits.

Launching our Chinese equity and bond expected returns

Our latest work around navigating ultra-low interest rates coincides with the launch of our expected returns for Chinese equities and bonds. Near-term risks to China’s economy, particularly surrounding geopolitical and trade frictions with the U.S., have prompted a cautious stance among global investors towards the country’s assets. Yet we see a strategic case for holding Chinese assets in portfolios that goes beyond tactical considerations. Our views on Chinese assets are not driven solely by the assumption that higher economic growth results in better expected returns. Instead, as for all other regions, they stem from fundamental considerations such as the outlook for interest rates, valuations and the path of returns.

Breaking down China’s growth outlook
Contributors to our bottom-up estimate of expected Chinese GDP and its historical performance, 1992-2029

Our new CMAs for Chinese asset returns allow us think about allocating to China in a whole-portfolio context rather than relying on index weights that will be shaped by other factors. We allow for a wide range of uncertainty in our return expectations to account for the multiple ways that China’s economy can evolve. Our base case is for a gradual growth slowdown in coming years, in line with IMF forecasts. Our growth expectations are based on a bottom-up approach featuring inputs on labour, capital and total factor productivity. A breakdown of Chinese growth – historic and projected – based on these inputs is shown in the chart above. We see growth decelerating below a 6% annual rate in coming years and eventually below 5% as the ageing population starts to drag as shown towards the right of the chart below.