22 July 2015

Put away your textbooks and brush aside almost everything you’ve been taught about bonds – investors should pay more attention to charts like this:

US treasury yields: 1980s versus today

US treasury yields: 1980s versus today

Source: Thomson Reuters Datastream, BlackRock Investment Institute, 20 July 2015.

This graph – which shows just how much bond yields have shrunk – stops us in our tracks every time we see it. The investment world has long hailed the benefits of adding bonds to portfolios and historically this has been a good bet. For decades, bonds have helped diversify portfolios and protected against volatility. They have offered a decent income, and a relatively smooth ride to get it.

Yet here we are in 2015, and the pre-crisis days of diversifying portfolios with government bonds yielding 5% are long gone. Years of easy money have pushed yields to rock bottom. And, while German bunds were the focus of a rout during May, there are fears a bigger, broader shock is brewing.

If not bonds, then what?

Against this backdrop it’s easy to see why scepticism about the traditional bond trade is building. Yet where else can more conservative income investors turn, when low interest rates, low yields and low inflation have helped inflate valuations across the board?

Running the BlackRock Global Multi-Asset Income Fund we spend a lot of time thinking about the question. Our approach is unconstrained so we have the freedom we need to zone in on opportunities when they matter most.

Right now, we’re invested across more than eight asset classes, 40 countries and 20 sectors. We’re concerned about the traditional bond call when played in isolation. Quite simply, safe haven government bonds are yielding too little, volatility is on the rise and correlations have tightened. Emerging market debt has historically been risky, and elsewhere, equity valuations look stretched even though Grexit fears have caused the FTSE and other stock markets to falter.

Find the right blend

At times like these, we think diversified portfolios really come into their own. Over time they have offered investors the most consistent outcome and on our sister fund, the BGF Global Multi-Asset Income Fund, we’ve combined this approach with a risk-first attitude and delivered an average annual yield of 5.5% since inception, yet taken less risk than a balanced portfolio1.

Over the three years we’ve been running the Fund we’ve shown harnessing diversification means investors can earn a decent income without taking significant downside risk – two of the main reasons why cautious investors have historically turned to bonds. Investors could consider going down in quality or out in duration. Alternatively, equities or property. Compared to building a diversified portfolio we don't believe buying one or even a few of these investments is sensible in today’s environment.

Guard against risk

Admittedly, diversification doesn’t eliminate risk – investors still need to guard against threats to their portfolios. At the minute, interest rate risk is a big concern. We think a rate rise isn’t too far off in the US and expect the UK to follow quickly, yet the markets aren’t pricing in a UK hike until Q3 2016, meaning some investors could be caught out if Mark Carney, the Bank of England governor, moves swiftly.

We’ve already seen how painful it can be when investors get duration calls wrong. Going into 2015 most expected US interest rates to go up in June. Early on, we decided any move would cause strain the front end of the yield curve, while at the back end big buyers like pension funds would provide a natural anchor. However when other investors followed suit, markets effectively priced in the move everyone had feared. We quickly repositioned and reaped the rewards when bond volatility spiked. Less nimble investors were punished.

No shortage of crisis

Today, while we have added modestly to duration, our stance remains pretty conservative. During Q2 we tactically added exposure at the front end and trimmed exposure at the back. For some time we have liked more niche areas of the fixed income market, such as structured credit. Non-agency mortgage backed securities, for example, stand to benefit from decent US growth and aren’t too sensitive to changes in interest rates.

Looking around the globe it is clear income-seekers need to think carefully about the risks of any investment they make. The world isn’t short of crisis thanks to the ongoing situation in Greece and concerns around the Middle East.

Going forward investors will need to be flexible too – moves in Chinese equities are just one example that hits this home. About eight weeks ago they were riding high, but now, after shedding 30%2, are in bear market territory. We don’t expect volatility like this to ease, and would be mindful of lower expected returns across asset classes.

Source:
1BlackRock, as at 30 June 2015. Based on the Luxemburg-domiciled BGF Global Multi-Asset Income Fund, which is run by the same team and uses a similar strategy to the BlackRock Global Multi-Asset Income Fund. Average of all A6 share class monthly dividends annualised since Fund inception on 28 June 2012. A balanced portfolio comprises 50% global bonds and 50% global equities.

2BlackRock, as at 6 July 2015.

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Years of easy money have pushed yields to rock bottom.