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Record-low government-bond yields, and the potential for much of the core developed market universe to enter negative yield territory, have led to legitimate questions around the long-term inclusion of bonds in client portfolios. While bonds have historically played various roles in a portfolio, such as low but steady returns, yield generation and liquidity provision, it is their protective role against portfolio losses that many investors find most important. But do bonds, specifically government bonds, really provide the degree of downside mitigation that so many investors want and need?
In short, we would argue that the answer is no. We believe bonds may still have the power to dampen normal portfolio volatility, but that their ability to offset portfolio drawdowns is likely to be lower in the future. We also believe bonds have lost much of their historical “distinctness”, namely their ability to avoid the typical trade-offs that characterise most downside mitigation agents. With these limitations in mind, we have laid out our proposed framework for considering strategies to replace the traditional protective role of bonds in client portfolios.
Seeking to reduce portfolio losses: the limits and trade-offs of bonds
Given that most of the volatility-dampening benefits of bonds are due to their having markedly lower volatility than equities and other risk assets, replacing this aspect of a portfolio is actually fairly straightforward: all that is needed are investments with lower innate volatility than risk assets and with imperfect correlations. In effect, the ability of bonds to effectively reduce portfolio volatility likely has not materially changed. However, this is not true with regard to their ability to offset large…
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