Views expressed are those of the authors and are subject to change. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. For professional or institutional investors only. Please refer to the risk section in the PDF available below.
BONDS HAVE HISTORICALLY PLAYED THE PRIMARY, AND OFTEN SOLE, PROTECTIVE ROLE IN A PORTFOLIO. In this function, they have historically been able to offer the extraordinary combination of compelling total returns, reasonable yields and equity risk mitigation, seeming to provide an almost cost-free insurance policy for a portfolio. However, there are good reasons for investors to worry about a continuation of this “extraordinary combination”. For instance, today’s lower yields imply a greater opportunity cost of holding bonds due to both a lower running yield and lower expected total returns. Our current intermediate-term (10-year) return assumptions for US core bonds, for example, range from 0.7% to 1.2% per annum,1 below likely inflation rates. And, with interest rates close to zero, the ‘runway’ for further yield compression (and its associated offsetting protective qualities) is less than it was in the past. The result appears to be that bonds have less protective potential than in the past and may offer this reduced potential at a higher cost.
As such, many investors are interested in ways to augment the protective qualities typically offered by bonds, complementing them with other downside mitigation strategies. In this paper, we suggest a framework for identifying, comparing and blending together various downside mitigation strategies that we hope will be helpful in this effort.
A new conceptual framework for seeking downside mitigation
We think investors should consider a broader, more comprehensive approach where the traditional defensive role of government bonds in a portfolio is undertaken not by a single instrument or strategy, but instead by multiple downside mitigation strategies. These strategies, in turn, should be considered based on: 1) the asset base needing protection; and 2) the risk scenarios being guarded against (Figure 1):
This approach necessitates that the selected instruments and strategies be aligned to the asset base being defended. For example, an equity-heavy portfolio requires different downside mitigation instruments than a fixed-income-heavy portfolio, with core duration being suited to the former but not to the latter, for which inflation-sensitive assets may be more appropriate. An equity portfolio with a large allocation to emerging markets will require different…
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1This reflects Wellington Management’s Investment Strategy Group’s intermediate capital market assumptions as of 30 September 2020 for various asset classes. Intermediate assumptions reflect a time period of approximately 10 years. They are assumed nominal returns that are expressed in annualised, geometric terms. Return assumptions are shown for unhedged currency exposure (unless otherwise stated) using the US dollar as the base currency. This is for illustrative purposes only and the returns and other assumptions provided are hypothetical and not representative of an actual account or Wellington Management strategy. As the analysis relies upon assumptions and other expectations of future outcomes, it is subject to numerous limitations and biases including subjectivity. Data does not consider transaction costs, management fees or other expenses associated with actual investing. ACTUAL RESULTS MAY VARY SIGNIFICANTLY AND AN INVESTMENT CAN LOSE VALUE. Investments cannot be made directly into an index. | Please review in conjunction with the “Important disclosures – Capital market assumptions” in the PDF available above. | This material is not intended to constitute investment advice or an offer to sell, or the solicitation of an offer to purchase shares, strategies or other securities. References to future returns are not promises or even estimates of actual returns a client may achieve.