Beyond Bonds: The New Diversifiers

For investors who remain bullish on government bonds, here’s a reminder of what that means: If you buy €100 in the benchmark Bund today, the German government will give you back €99 in 2026, given the negative interest rates now in effect.

Put another way, says Andrew Sheets, Morgan Stanley’s chief global cross-asset strategist, based on his team’s long-term return models, buying a 10-year Bund today would be roughly equivalent to having bought the S&P 500 in November 2000 and held for the next 10 years. “Value isn’t the first word that comes to mind,” he says.

The difference may come down to horizon. An investor who bought Bunds two weeks ago, as a short-term hedge against the disruptive uncertainty following the Brexit vote, would have been rewarded as German bond prices rallied defiantly into that weekend. For those required to take a longer view, however, rich bond valuations challenge a fundamental premise of asset allocation: Bonds are widely viewed as portfolio diversifiers, and have been exceptionally good at this role. But amid zero or even negative interest rates, can this continue? And if not, what are the alternatives?

Here’s how Sheets quantifies the problem. Over the past 17 years, the 10-year government debt in the U.S., Germany, UK and Japan—considered among the most stable financial investments in the world—has produced a better return than their respective local equity markets, and with lower volatility to boot. Over the next 10 years, however, “our long-term return models suggest something different,” he says. “Based on our expected returns for both bonds and stocks, and using historical volatility, 10-year government debt will post worse risk-adjusted returns than equities (or credit) over the next decade.”

That’s the only performance measure likely to deteriorate. Government bonds have been unusually good at buffering equity market moves. Since the late 1990s, whenever equities have declined, bond prices have climbed. This shock-absorbent negative correlation—zigging when the stock market zags—has provided many investment portfolios with additional diversification.

Yet, that wasn’t always the case. Between 1950 and the late 1990s, for example, the correlation between the S&P 500 and U.S. Treasuries was positive. In that period, equity and bond prices tended to rise in tandem.

Could the negative correlation of today revert to the positive correlation of yesteryear? Sheets says, yes, pointing to one key condition: Bond interest rates simply don’t have enough room to fall further to offset equity market declines. “Take a 60/40 portfolio constructed today from the S&P 500 and U.S. Treasuries,” he says. “To make up for a 10% decline in the equity market, Treasury yields would need to go… negative. Not impossible, but certainly a high hurdle!”

Investors in European and Japanese bonds are already seeing a clear example of this dilemma, with Bunds and Japanese government bond prices simply unable to rally enough to offset recent equity market declines because their yields are already negative.

To be sure, such government bonds still play a big role for many investors, particularly among large institutions, such as pensions, endowments, or insurers, among others and demand for them should stay strong. Investors will continue to buy government bonds, says Sheets, because “they are liquid, meet important regulatory requirements, and have continued to outperform expectations.” Also, given current expectations for disappointing economic growth over the next 12 months, bond yields could remain well-supported, despite rich valuations.

For those with a longer-term horizon, however, Sheets urges some serious thinking about other tools for diversification. Reliable cost-effective diversifiers are hard to find. Still, here are seven that he and his team offer up for consideration:

1. The dollar, yen and Swiss franc could be promising currency “safe havens” during equity market downturns;
2. Healthcare and utilities sectors, already deemed defensive plays, can offer investors more security and diversification in a down market;
3. Selling equity volatility via the VIX, an index of protective hedge positions sometimes called the “fear gauge,” which ironically can be a better diversifier than buying the VIX, Sheets says, due to the high-volatility risk premiums that have persisted since the financial crisis. The same goes for credit-default-swap indices, which work better as diversifiers when selling protection than buying it;
4. Going down in credit quality for yield (think high-yield bonds), rather than going out the duration curve. “Corporate credit and municipals look particularly attractive on a tax-adjusted basis,” Sheets says.
5. Equity Value has been a relatively poor diversifier, whereas FX Value looks more promising;
6. Equity Quality and low volatility typically fare much better than Value as diversifiers;
7. Gold continues to be a go-to safe haven, although its value as a deflation hedge is undermined by lack of volatility cushion, lack of hedge offset and portfolio drawdowns being more severe than an underlying equity portfolio.

In each of these diversifiers, the goal is to look for assets that outperform in down markets, come with reasonable drag when times are good, and trade at valuations that are less extreme than what is found in global government bonds.

For more Morgan Stanley Research on the outlook and strategy for global markets, ask your Morgan Stanley representative or Financial Advisor for the recent Sunday Start commentary, “New Diversifiers Needed” (Jul 17, 2016), and the full report, "Cross Asset Strategy: The New Diversifiers” (Jul 7, 2016). Plus, more Ideas.