Sovereign bonds as a source of downside protection
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Sovereign bonds as a source of downside protection

As with every end-of-year period, the past few weeks have churned out various articles and reports summing up the highlights of the past year. All did not fail to mention the return of volatility across financial markets. Needless to say, when fear hits home, riskier assets tend to be the hardest hit, hence the double-digit declines witnessed across most developed and emerging market equities during 2018.

US equity investors, despite closing the year lower, had a less torrid end. However, in Europe, the German DAX topped the list of fallers with an 18.3 per cent decline and in China equities lost over 25 per cent.

During the same period, most bond investors also had a difficult year, yet losses were much more contained. On a total return basis, emerging markets hard currency bonds lost just under four per cent, Sterling denominated bonds declined by 2.3 per cent, US corporate bonds lost nearly two per cent and global high-yield bonds declined by 3.3 per cent.

On the flip side, high-quality US sovereign debt and Sterling sovereign debt posted gains of 1.4 per cent and 1.3 per cent respectively.

It is interesting to note that with heightened volatility during the last rolling three months, we also witnessed a strong performance by most fixed-income assets. In the midst of the volatility witnessed across global equity markets during the last few months of 2018, high-quality sovereign bonds were among the top performers – the reason being that sharp increases in market volatility make investors uneasy and, as is usually the case, when risk aversion kicks in, investors opt for safe haven assets. Time and again high-quality sovereign bonds have proven to be among the main go-to assets, during time of turmoil or when recession fears set in.

This is good news for those investors who are strong believers of asset class diversification. Most investors understand that diversification reduces portfolio risk because spreading your money across different investments reduces your portfolio exposure to a particular asset or security.

However, asset class diversification also has another aim – having assets in a portfolio which do not move in tandem protects your portfolio from heavy fluctuations. The belief that bonds and shares move in opposite directions is too general and one needs to dig deeper and understand that different bonds and shares react differently during different economic periods.

For instance, there are little diversification benefits from having a portfolio of high-yield bonds and equities since both asset classes tend to be strongly correlated – that is, they tend to move up and down together.

Investors should rethink their portfolio’s asset allocation. Adding assets which are not strongly correlated to risky assets is a must

On the other hand, the correlation between high-quality sovereign debt and equities is much weaker and hence make a good case for diversification. An investor who held an index tracker which tracks the S&P500 lost nearly two per cent during the last three months, while another investor who held a portfolio split equally between US equities and US Treasuries gained nearly one per cent.

Over the past decade demand for sovereign debt increased significantly, both locally and internationally. As central banks suppressed interest rates, many income investors sought returns in fixed-income assets, among others. Long-dated sovereigns were among the main beneficiaries, since they are longer duration assets which offered better upside returns compared to shorter-term bonds.

This time around, the benefits of holding sovereign bonds in a portfolio will be different. Various economic and market forces will shape the next decade differently compared to the last. There is a long list of events which could elevate market risk but one major change which tops the lists of many analysts is less accommodative central banks.

Various articles have been written on the risks which the switch from monetary easing to monetary tightening pose to global economies. We agree that this shift will elevate risks and market volatility but will also offer various entry points to investors in the years ahead.

In addition, at this point we see a greater case for asset class diversification. This time round, high- quality sovereign debt will most likely not contribute to a portfolio by generating double digit total returns. Nor will they generate high-income levels, since yields on most developed market debt are still rock bottom. Yet, good quality sovereign bonds will protect portfolios on the downside when volatility is on the rise.

It is evident that the next decade will not be as easy as the last one, hence investors should not just look at the coupon or income yield which an asset class generates. In an environment where volatility is expected to remain elevated, asset class diversification is key. High-quality sovereign bonds will support investors’ portfolio during negative periods.

We have already witnessed this over the past few months. Local investors who hold euro and wish to diversify their foreign equity portfolio in order to reduce volatility, can invest in both Malta Government Stocks or high-quality European sovereign debt, namely German bunds. Those who hold US dollars can consider US Treasuries.

High-income and high-capital returns are two major investment objectives of most local investors. Yet, the highest-yielding asset classes are also the most volatile. Investors who have invested in local equities and foreign markets – both equities and bonds – know that last year their nerves were kept constantly in check. We believe that volatility is here to stay and hence investors should rethink their portfolio’s asset allocation. Adding assets which are not strongly correlated to risky assets is a must. How much should be allocated to low and higher-risk assets depends on the individual’s risk tolerance.

This article was prepared by Gabriel Mansueto, branch manager and senior investment advisor at Jesmond Mizzi Financial Advisors Ltd. This article does not intend to give investment advice and the contents therein should not be construed as such. The company is licensed to conduct investment services by the MFSA and is a member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company, and their clients are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For more information, contact Jesmond Mizzi Financial Advisors Ltd of 67, Level 3, South Street, Valletta, on 2122 4410 or send an e-mail to gabriel.mansueto@jesmondmizzi.com.

www.jesmondmizzi.com

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