Bonds Jul 18

The role of bonds in a crisis

One of the observable trends during distressed markets is the 'flight to quality', but in the case of the Covid-19 pandemic we have seen a 'flight to cash', Vanguard's Yan Pu writes

The role of bonds in a crisis
Image: AFP.

(ATF) The economic repercussions of the Covid-19 pandemic have brought significant volatility in the past few months, with investors looking to their bond exposures to cushion some of the blow in times of equity decline.

In March, however, the value of fixed income securities and funds fell across a wide range of durations and currencies. Even the traditional 'safe haven' of developed market government bonds failed to provide refuge from the market turbulence in this period, with yield curves rising at certain periods to compound investor pain.

The simultaneous fall in both bonds and equities has raised questions about the diversification benefits of fixed income securities and their role as shock absorbers during periods of market distress.

The rationale for maintaining a balance between bonds and equities is based on the understanding that bond returns tend to move in the opposite direction to equity returns. A healthy exposure to bond markets should provide investors with a cushion to absorb some of the losses when equity markets inevitably tumble. This feature is normally enhanced for longer-duration bonds as highlighted in the below figure.

Performance of government bond indices for different durations during worst quartile of equity performance

Past performance is not a reliable indicator of future results. Sources: FTSE All World Net Total return index and Bloomberg Barclays US Treasury Total Return Unhedged USD indices. Data from January 2005 to May 2020.

So, why were bond valuations falling at the same time as equities? And does that mean that the relationship that we have been relying on for asset allocation is dead and that bonds no longer play the role of risk diversifiers in a multi-asset portfolio?

One of the observable trends during distressed markets is the 'flight to quality', but in the case of the Covid-19 pandemic we have seen a 'flight to cash'. By that we mean investors are selling their equity and higher-risk bond (high-yield) positions, holding the cash and waiting for the volatility and uncertainty to reduce.

Similarly, asset managers facing redemptions tend to sell their most liquid assets first, which are typically developed market government bonds and high-quality corporate bonds. This has put further downward pressure on bond prices as it happened in tandem with the economic reaction to the spread of Covid-19 (eg, layoffs, declines in growth as a result of the containment measures).

Although difficult to forecast, the flight to cash is likely to be temporary, and once market confidence bounces back and investors buy back into marginally riskier assets, the correction could be sharp.

Another explanation is that the large fiscal packages that have been rolled out in the US and Europe have put upward pressure on government bond yields as markets price in the added credit risk associated with more borrowing.

If the fiscal stimulus works, though, we should see a reversion in government bond yields over the next couple of months. We have actually seen this happening in recent weeks.

In fact, we should think about why equity and bond returns tend to move in opposite directions. The conditions for that to hold are related to how monetary policy responds to equity sell-offs.

Over the past 20 years or more, since central banks widely adopted inflation-targeting policies, they have responded to economic growth shocks by rapidly lowering interest rates (and therefore bond yields), which ultimately pushes bond returns up. This is exactly how central banks have been responding to the Covid-19 shock.

Of course, this dynamic does work less effectively when interest rates are already low, as in the current economic environment. When yields are already very low, there is less room for them to decrease further and therefore bonds provide less downside protection compared to a high interest rate environment. But even then, they still provide some protection.

High market volatility is the result of many variables impacting the market at the same time, including irrational human behaviour. With that in mind, we can't expect the negative correlation in equity and bond prices to hold each and every day, but rather on average over the investment horizon.

For now, there is no reason to abandon the long-standing position that bonds will perform their duty as shock absorbers in multi-asset portfolios.

Yan Pu is managing director and head of Investment Management Group in Asia for Vanguard Group

Vanguard Group, based in the US, is one of the world’s largest investment management companies and owned by Vanguard mutual funds, which in turn are owned by investors in those funds. This structure aligns Vanguard’s interests with those of its investors and drives the culture, philosophy and policies throughout the group, which has offices in Hong Kong, Japan and Shanghai. Globally, Vanguard manages US$5.9 trillion (as of 31 May 2020) in mutual fund, separately managed account and ETF assets. For more information, visit www.vanguard.com.hk.