How will bond portfolios react if the US election triggers further market mayhem? Fallout from Brexit taught us valuable lessons about extreme market shocks.
Bond markets are still digesting the full implications of the Brexit vote. But it’s already revealed key insights into building more volatility-proof portfolios.
Lesson 1: Diversification delivers
[drizzle]Benchmark-driven bond investing forces investors to back only one specific part of the bond universe—so it can really hurt if these bonds lag. But active bond funds can hold many different kinds of eggs across many different baskets and, together, they can help keep risks in check.
The Brexit vote proved a decisive vindication of the benefits of building a well-diversified set of bond exposures and being skeptical when financial markets take a consensus view.
Before the vote, markets were behaving as if the UK had decided to remain. The British pound and UK equity markets were making gains and UK government bonds (gilts) were selling off. Stepping away from the crowd and buying into gilts at attractively cheap prices ahead of the vote proved highly beneficial.
Lesson 2: Seek safe havens with decent yields
“Safe-haven” bonds—the highest quality government debt—are expected to hold on to, or increase, their value when other assets sell off. But bonds with yields below 1% are much less effective at absorbing market shocks. Their yields simply can’t fall much more, so their prices can’t rise meaningfully, when riskier assets sell off.
After the Brexit vote, government bonds with decent yield buffers—gilts, Australian and Canadian government bonds and US Treasuries—significantly outperformed their counterparts with ultra-low and negative yields, like German Bunds and Japanese Government Bonds (JGBs).
The compression of safe-haven bond yields is also enhancing the appeal of safe-haven currencies as effective shock absorbers. During Brexit-driven turbulence, the value of safe-haven currencies like the Japanese yen and the Swiss franc rose more than the value of either JGBs or Swiss government bonds.
Lesson 3: Build bond balance
One of the key ways that bond portfolios have traditionally offered good ballast is by combining credit and interest-rate risks.
But there’s little balance in the big bond benchmarks that dominate many investment strategies. The interest-rate, or duration, element has soared as governments and companies have taken advantage of cheap borrowing costs to extend the maturity of their debt. Benchmark-tracking investors are overloaded with exposure to interest-rate risks—and earning precious little income in the process. The duration of the main global fixed-income index, the Bloomberg Barclays Global Aggregate Bond Index, has increased by about 40% over the last few years, while its yields are about one-sixth of what they were.
Some active bond fund managers have responded to this imbalance by aggressively dialing down duration and ramping up exposure to credit—which is less sensitive to interest-rate volatility. But credit is much more closely correlated with equity-market moves than longer-dated government debt. Going ultra-low, or negative, duration and owning mainly credit hurt when equities sold off after the Brexit vote.
Carefully blending credit and interest-rate risks helps ride out volatility.
Lesson 4: Take the sting out of tail risks
Active bond managers are increasingly deploying strategies that offer extra protection during periods of extreme market stress or “tail risk.” Tail-risk hedges work like insurance policies—they come at a cost, but can pay out handsomely when trouble strikes.
Like any other asset, some tail-risk hedges offer better value for money than others. It takes skill to identify pricing anomalies and opportunities. For example, selling the Mexican peso has become a hugely popular hedge against a Trump victory. But the peso’s big losses to date suggest this hedge’s effectiveness has been greatly undermined. The currency could rally sharply if Clinton wins, badly burning investors who sold it as a protective hedge.
Lesson 5: Thwart liquidity traps
Several UK commercial real estate funds were forced to suspend trading during Brexit-related volatility because they couldn’t sell their illiquid assets fast enough to meet demand from fleeing investors. These liquidity traps reinforce the importance of being able to respond nimbly to sudden price swings when market mayhem strikes. Investors confined to a single bond sector—say, high-yield or emerging-market debt—may not be able to trade when selling in that sector spikes and liquidity dries up.
But investors holding lots of different bonds can combat liquidity droughts: they can quickly and easily move into another sector—say, investment-grade corporate bonds—where liquidity is more plentiful.
Brexit is a cautionary tale ahead of the US presidential polls. There’s a risk in every event and overconfidence in one particular outcome can prove highly dangerous. But well-prepared bond investors can protect themselves from much of the investment damage inflicted by unexpected upsets.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.