We’ve All Got A Bonds Problem

No, not that Bonds problem…   We’re talking everyone’s favorite fixed income investment, municipal, government, and corporate bonds.

The folks who bring us the nifty chart of asset class performance throughout the years,  Callan Associates,  is out with some research on diversification, showing just how much diversification is needed these days to capture the same 7.5% return you used to be able to get from just a bond allocation back in the day (1995).  Funny, 1995 seems about 20 years ago – that feels right; while the concept of 7.5% annual yields on treasuries seems like something out of a science fiction book on an alternate universe thousands of years ago.

The Wall Street Journal got a hold of this diversification piece and put their spin on it as having to take on more risk these days to get the same return.  Specifically, they pull out a nifty chart showing the expected return and “risk” (the standard deviation of those returns) of different asset mixes over the years.

Thanks to rock-bottom interest rates in the U.S., negative rates in other parts of the world, and lackluster growth, investors are becoming increasingly creative—and embracing increasing risk—to bolster their performances.

To even come close these days to what is considered a reasonably strong return of 7.5%, pension funds and other large endowments are reaching ever further into riskier investments: adding big dollops of global stocks, real estate and private-equity investments to the once-standard investment of high-grade bonds. Two decades ago, it was possible to make that kind of return just by buying and holding investment-grade bonds, according to new research.

Bonds

The reality is that markets aren’t what they used to be, and especially the bond markets. For all those who cried out warnings of unintended consequences during bailouts, QEs, and the rest. This is it. We’re there.  We’re in a world where investors give the German government their hard earned money, and 10 years later – get back less of it. That’s not how investments are supposed to work, as far as we know…especially 10-year ones.  What’s worse – the volatility of these markets doesn’t appear to be decreasing with decreased return expectations. Bonds, in particular, are in a unique spot where they could be in a big spot of trouble when and if interest rates ever tick back higher, causing principal losses before retracing back to even upon the end of the bond’s term.

Now, we looked at this chart and immediately thought a few things. One, a 17.2% annualized volatility seems a bit high to us. Do you really need to accept that sort of volatility? Two, this exercise is clearing not considering the best risk-adjusted returns – and allocating more to those assets which deliver more return per unit of risk (volatility). If it was, bonds would be excluded. And finally – where is managed futures?  They are a classic portfolio diversifier and volatility reducer (see Efficient Frontier Graph).

An easy change to their asset allocation addresses a bunch of these issues, mainly, swapping out the bond allocation for managed futures. Now, those who hold fixed income sacred may cry foul – but the numbers support managed futures as a “bond replacement.” Consider the days of bonds having high returns and low volatility are a thing of the past – with the new regime nearly the exact opposite of low returns (if not negative) and higher volatility. Managed futures, meanwhile, have remained steady over the past 10 years… with an annualized volatility of 7.35%, which is far below the expected volatility of various asset classes via Callan (note we’re using past volatility, while Callan is using expected volatility).

Bonds

Data Courtesy: Callan Associates

Managed Futures = SG CTA Index

Getting back to the asset allocation change, there’s no denying that you have to take on more risk than before, but you may not need to take on as much risk as Callan and the Wall Street Journal suggest.  We ran the numbers on a different portfolio, replacing the problem child (bonds) with Managed Futures and shaving a bit off of equities, and came up with roughly the same annualized return with significantly lower volatility. [Note we used the past 10-year annual return for Managed Futures and used Callan’s expected returns over the next 10 years while adjusting by a constant to allow for an apples to apples comparison without knowing all of Callan’s inputs in order to calculate the 7.5% expected return].

Bonds

Data = Managed Futures via SG CTA Index

Managed futures doesn’t look too shabby as a bond replacement in the above. But that’s only half the story. Managed Futures ability to use notional funding means there’s the ability to increase the returns (and the volatility) to desired (acceptable) levels.  Using the same allocation as the above chart, we went back and leveraged the managed futures returns, first putting up ½ the needed capital, then 1/3 the needed capital; which effectively doubles and triples the risk and return of that allocation.  Here are the return and volatility numbers upon utilizing managed futures built in leverage ability (Disclaimer: The use of leverage can lead to large losses as well as gains).

Bonds

(Disclaimer: The use of leverage can lead to large losses as well as gains).

In the end, these are important charts to consider when constructing (or reviewing) your portfolio. The game is harder, and many investors are having to “juice” the portfolio with diversification and alternatives just to get the same return boring old bonds delivered 2 decades ago.  There is no free lunch, as the cliché goes, and this diversification and reach for yield come with increased risk for portfolios – in the form of increased volatility. But not all alternatives and diversification options are equal. Some come with a long history of low volatility. Some come with the ability to target desired returns and volatility via built-in leverage.

There are many ways to diversify. But it’s clear bonds are no longer the standard they once were for providing a counter to stocks in your portfolio, with alternative investments needed to act as bond replacements. Download our “Why Alternative Investments?” whitepaper, to educate yourself on what you should be looking for in investments outside of the traditional realm.