Bonds do not need to be negatively correlated with equities in order to reduce total portfolio volatility, argued Laura Ryan, head of research at fixed income investment boutique, Ardea Investment.
Presenting research at Conexus Financial’s Fixed Income and Private Credit Forum, Ryan demonstrated that volatility was reduced even in a correlation scenario of 100 per cent between bonds and equities. This was true in both a low yield environment and an environment of rising interest rates.
Ryan argued the low yield environment of recent years had put a focus on the positive correlation between bonds and equities. But as markets move to an environment of higher inflation, bonds will reduce the volatility in a portfolio as long as they exhibit lower volatility than equities, even if they have a very strong positive correlation, Ryan said.
Bond equity correlation
“You do get a better outcome if the correlation between bonds and equities is negative, but that’s a secondary consideration,” Ryan said.
Ryan showed the scenario of a 60/40 portfolio of hedged equities to hedged bonds, finding equities contributed 103.2 per cent of the volatility while the bonds contributed minus 3.2 per cent. Bonds were 98 per cent correlated with equities.
But while bonds only appeared to be making a small negative contribution to reducing volatility, a portfolio with 100 per cent equities without bonds would have a volatility of 24.6 per cent, whereas the addition of 40 per cent bonds to this portfolio had brought volatility down to 14.2 per cent, she said.
“So the point is that despite the fact that this portfolio is still strongly correlated with equities, it’s not exhibiting the same volatile swings,” Ryan said.
Speaking in the same session at the forum, Jeff Klingelhofer, co-head of investment and portfolio manager at global investment management firm Thornburg, said rising inflation was forcing investors to look at fixed income from a more bottom-up perspective.
In talking about the role fixed income was to serve in portfolios, Klingelhofer made the point the US Fed’s mandate included moderate long-term interest rates. In a discussion with a former Fed official, the official told Klingelhofer that he could not care less about asset prices.
The funds management industry may not fully grasp the implications of this when markets move from problematically low inflation to problematically high inflation, he said. “When inflation is high, markets go down because we’re tightening policy and slowing growth, and the central banks just say ‘look, that’s your problem, we’ve never been in the business of supporting asset prices, that’s not our game’,” Klingelhofer said.
In an environment of around two per cent inflation, fixed income has good correlation characteristics for a portfolio, but an environment of higher persistent inflation necessitates looking at fixed income differently, he said.
“Rather than looking for the top down, look from the bottom up,” Klingelhofer said. “And even more importantly, look across silos. Because my basic argument to you is, when you look across silos, it creates an opportunity to upgrade your portfolio with relatively minimal cost in terms of total return and income generation.”