Traditional portfolios made up of 60% equities and 40% bonds will increasingly become a thing of the past, according to Rupert Thompson, chief investment officer at Kingswood.
Thompson says there is “no doubt” that bonds no longer provide the protection they used to, particularly among government bonds. Corporate bonds are also hovering close to all-time lows, making them vulnerable to significant spread widening in a risk-off move.
Thompson explains: “A major new risk-off move is now looking as likely, if not more likely, to come from worries of overheating, a marked rise in inflation and Fed tightening rather than too little growth or deflationary fears as has been the norm over the last decade. If so, far from government bond yields falling in a risk-off move, government bond yields would be rising. In essence, government bonds would no longer be negatively correlated with equities but positively correlated, thus removing most of the protection benefits of holding government bonds.”
Thompson warns that with government bonds at zero or negative, they no longer provide a hedge against inflation and if inflation were to pick up significantly, real yields could turn more negative with governments and central banks both keen to limit any rise in yields.
With index-linked bonds very expensive and inflation-linked bonds long duration and exposed to any rise in real yields, Thompson argues that increased inflation risk should therefore only partially be met by inflation- linked bonds with additional inflation protection coming from other sources.
He explains: “The outlook for inflation is also crucial in determining the optimal allocation going forward. This should be rather clearer in a few years’ time when it should be much more apparent whether we have moved into a new inflationary era or are back to the disinflation of the last decade.
“What is clear however, is that the ideal bond allocation for any portfolio is significantly lower than in the past. That said, while bonds generally are looking expensive and unattractive, there are still pockets of relative value in areas such as emerging market bonds. These have a role to play due to their different risk/return characteristics to developed market bonds and emerging market equities.”
Replacements for bonds will focus on alternatives with low correlation to equities and bonds, says Thompson. Real assets such as gold, infrastructure and property could provide some protection. Similarly, crypto-currencies may feature in the future, however the current price volatility means they are not a likely candidate for the time being.
