Practical analysis for investment professionals
22 June 2020

No Longer Superheroes? Twilight of the Bonds

Fixed-Income Kryptonite

“Faster than a speeding bullet. More powerful than a locomotive. Able to leap tall buildings in a single bound.”

And he can fly and shoot lasers from his eyes.

Superman not only has the best superpowers, he is also handsome, charming, and humble. Plus he dearly loves his mom and farm.

He might come off a little boring and straitlaced compared to more colorful characters like Ironman or Thor, but he’s clearly the superhero who wins over the most hearts.

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One-on-one, no one can outmatch him. Except perhaps someone who brings the proverbial gun to a knife fight. In this case, that gun is Kryptonite, Superman’s only known weakness. The substance renders his powers useless and makes him a normal man — one who can feel pain.

In the investment world, fixed-income instruments have their own Kryptonite: quantitative easing (QE). The central banks’ unconventional monetary policy of buying longer-term securities from the open market to increase the money supply and encourage lending and investment has pushed bond yields in most developed markets toward zero and even into negative territory since the global financial crisis (GFC).

Interest rates have gone negative in Japan, and briefly fell below zero in the United Kingdom. The latter has increased its public debt due to the COVID-19 crisis, which ought to make it less creditworthy. Yet the United Kingdom has just issued its first negative yielding bond.

Over the last 40 years, bonds were the superheroes of investment portfolios. They generated high risk-adjusted returns given steadily declining yields and were mostly negatively correlated to equities and therefore provided attractive diversification benefits. Some investors, such as Ray Dalio at Bridgewater Associates, built their empires on the back of this tailwind.

But with low, nil, or negative yields, how much can bonds still contribute to a portfolio? Has the QE Kryptonite permanently disabled their superhero powers?

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The Japanese Example

We could run complex Monte Carlo simulations to demonstrate the impact of low-yielding bonds within asset allocation, or we could simply use Japan as a real-life case study.

The land of the rising sun played an outsized role in the global economy in the 1980s. It reached its apogee in 1989 when its stock market achieved a 45% share of the global market cap compared with only 33% for the United States. But Japan’s economic power was fueled by an asset bubble of epic proportions. It eventually burst, as all bubbles do, and the economy has never fully recovered. Why? Because Japan’s banking system was not thoroughly restructured, which led to a partial zombification of the economy that was made worse by a demographic crisis.

The Japanese government and central bank have taken aggressive and at times unconventional measures to stimulate the economy since the early 1990s. But the long-sought-after recovery is still elusive, and while the banking system has improved, an aging and shrinking population makes the prospects for a full-fledged revival increasingly remote.

Because of its monetary policy, the Bank of Japan now owns large chunks of the Japanese stock market, and the 10-year government bond first traded at negative interest rates in 2016.

Japanese 10-Year Government Bond Yield

Chart showing Japanese 10-Year Government Bond Yield
Source: FactorResearch

60/40 in a World with Diminishing Superhero Powers

Japan’s 10-year government bond yields fell consistently below 2% after 2000. So 2000 will mark the start of our traditional 60-40 equity-bond portfolio simulation. The Nikkei 225 will be our benchmark for equities and an index of mostly Japanese government bonds our benchmark for fixed income.

Stocks in Japan were up over the 20-year period. But just like their global counterparts, they crashed during the tech bubble implosion in 2000, the GFC in 2008, and the COVID-19 crisis in 2020.

Bonds were negatively correlated to equities in Japan and therefore offered considerable diversification benefits. In addition, bond yields declined from 2% to 0%, generating attractive capital returns. This meant that a traditional equity-bond portfolio delivered higher total returns than a 100% allocation to equities. This same dynamic played out across most developed markets.

Stocks vs. Stock and Bond Portfolio in Japan

Source: FactorResearch

Why include bonds in a portfolio? The primary reason is risk reduction. Bonds are, on average at least, less risky than stocks. But most of the financial research highlighting the benefits of fixed-income allocations are based on the last few decades, when structurally declining yields across markets meant bonds had a stand-alone appeal. They were an easy sell.

The case for bonds is less clear amid higher inflation. US fixed-income returns were eaten up by rising inflation during the oil crisis in the 1970s. This meant significant negative real returns for investors. Inflation risk is seemingly remote now, but governments might decide at some point to tackle the global debt problem by allowing inflation to grow rather than dealing with a nasty eventual debt restructuring.

And what’s the rationale for bonds when yields are close to zero or even negative? It’s simply an asset class with no positive expected returns.

Naturally, there are many different kinds of bonds and some, from emerging markets, for example, still offer high yields. However, these come with much higher credit risk and are certainly no free lunch, especially since leverage in emerging markets is at an all-time high across governments, corporates, and consumers.

In Japan, a traditional equity-bond portfolio had lower drawdowns than an all-equities portfolio during the GFC in 2009 and the COVID-19 crisis in 2020. But it was still no improvement to simply hold cash rather than bonds.

Japanese Stocks vs. Stock and Bond Portfolio: Drawdowns

Bar chart showing Global Pension Asset Allocation
Source: FactorResearch

A World without Superman

In one film, Superman died after touching Kryptonite and losing his superpowers. But when humanity was once again on the brink of destruction, he came back to life and saved the planet with the help of a few of his fellow superheroes.

Bonds have touched kryptonite and lost their superpowers, too. And asset owners seem woefully unprepared for a world without them. The average allocation to the asset class has held steady at 30%, almost as if it was on autopilot, since 1999, according to the “Global Pension Asset Study 2020” from the Thinking Ahead Institute. But in the 1990s, Japan’s 10-year government bond yielded 2% and the US 10-year 5%. Today those yields are 0.0% and 0.7%, respectively. That the 30% fixed-income allocation hasn’t changed highlights the underlying absurdity.

Investors have adjusted their asset allocation mix by shifting capital from equities to alternatives. The three stock market crashes over the last 20 years have left deep scars in the minds of allocators. In contrast, during that same period, such alternatives as private equity, real estate, and infrastructure generated attractive and seemingly uncorrelated returns. On paper, they look great and it’s hard to resist their siren call. But alts are no superheroes. They’ve benefited from falling interest rates and represent bets on economic growth. They provide similar exposure as equities.

Global Pension Asset Allocation

Source: Thinking Ahead Institute, FactorResearch

Further Thoughts

The funding ratio of US public pensions declined from 74% before the COVID-19 crisis to about 60% currently, according to estimates from Goldman Sachs. Most public pensions still assume a 6%–7% annual return. That is practically impossible with so much of their portfolios invested in an asset class with zero or negative rates and that is hardly risk-free.

And unlike Superman, bonds won’t be making a miraculous recovery and coming back to rescue us. So it’s time to bet on the others, even if they have less appealing powers and are frequently unreliable.

Unconventional times require unconventional asset allocations.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images / Devrimb

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About the Author(s)
Nicolas Rabener

Nicolas Rabener is the managing director of Finominal, which provides quantitative solutions for factor investing. Previously he founded Jackdaw Capital, a quantitative investment manager focused on equity market neutral strategies. Previously, Rabener worked at GIC (Government of Singapore Investment Corporation) focused on real estate across asset classes. He started his career working for Citigroup in investment banking in London and New York. Rabener holds an MS in management from HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (100km Ultramarathon, Mont Blanc, Mount Kilimanjaro).

5 thoughts on “No Longer Superheroes? Twilight of the Bonds”

  1. Kirk Cornwell says:

    Yes, “things are different now”, especially for pension funds that have blithely assumed average 7% returns over time. Will the Fed bail them all out?

  2. Peter says:

    When equities have the advantage over fixed income in both growth and yield (think total shareholder yield, dividends + buybacks), then portfolio managers are probably better off reallocating to 100% equity and using the incremental yield picked up to purchase tail risk protection in the form of deep out-of-the-money puts.

    Alternative investments do make sense in some instances, but due diligence costs are high, transparency is low, and the associated high return / low risk / low correlation claims are at best exaggerated and at worst fraudulent.

    1. Nicolas says:

      Hi Peter, thanks for sharing your perspective.

      I agree with Norbert’s comments that certain low-cost and transparent liquid alternatives like managed futures / CTAs can be used to partially replace fixed income positions. However, none will be reproduce anything like the bond bull market of the last 30 years, so the base expectation should be lower returns and higher volatility.

      Regarding buying tail risk protection: the track record of managers in this space is not particularly appealing, despite recent headlines of outsize returns during the COVID-19 crisis. Here is a research note with some further details on the performance of tail risk hedge funds:

  3. Norbert Mittwollen says:

    @Peter: Just limit alternative investments to a choice of purely traditional trend-following managed futures, such as in the SG Trend Index or the like, i.e., without the relative value stuff. Opposite to more than 90% of alternatives, these really make much sense in most instances. Due diligence costs are ok, transparency is high, the equity-like high return / adequately high risk / sustained non- and – during severe crises – anti-correlation and long directed volatility characteristics are uniquely beneficial diversifiers, crisis protection and high return sources. Thus, they are an even better replacement for bonds. See my contribution on 25 June 2020 with some more details:

  4. Sijing Wu says:

    Yes, “Everything is different now”.

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