Save the Barbells for the Gym

Today’s environment calls for diversified bond portfolio strategies rather than the traditional barbell approach of combining equities with cash.

For Australian investors, the barbell strategy aims to balance high risk assets (usually equities) with very low risk assets (typically cash or term deposits). At the recent Morningstar Conference, this portfolio construction methodology was the subject of significant debate. We believe this approach is not effective in striking a balance between reward and risk, particularly with cash and term deposit rates anchored at near zero in an environment where inflation is starting to creep higher.

Below we summarise three key reasons why investors should consider a more diversified portfolio that includes an allocation to core bonds and credit.

1. Core bonds offer higher return potential than cash and term deposits

There are various risk premia available to investors looking to generate a return above the official cash rate (currently 0.10%), including equity risk premium, credit risk premium, term risk premium (also known as duration or interest rate risk) and illiquidity risk premium. While many risk premia are trading on the rich side, term risk is the only premium that has recently repriced markedly. This makes bonds one of the few asset classes that have become more attractively valued over the past year.

The Reserve Bank of Australia (RBA) has indicated that it will not increase the official cash rate until actual inflation is sustainably within its 2%–3% target range, which it has stated is unlikely to be until 2024 at the earliest. With all of the discussion around rising rates, it can be easy to forget that bond markets are forward-looking and price in expectations for future rate movements ahead of time. In fact, they have already priced in the first rate hike for late 2022, with the official cash rate priced to reach close to 1.5% by the end of 2024 (see Figure 1).  This repricing of bond markets that has already occurred leads to our base case expectation that yields will remain relatively range-bound moving forward.

Figure 1: Market expectations for rate rises move ahead of RBA’s stated outlook

Since the start of August 2020, the yield on Australian government bonds has risen by around 1% to between 1.5% and 1.7%, leading to the largest margin in terms of an estimated return (or carry) over cash and term deposits in some time (see Figure 2). Investors can pick up more than 200 basis points (bps) in excess return expectations over cash when investing in core bond funds right now. The recent rise in longer-term bond yields along with steeper yield curves not only increases the margin over cash, but also means that bonds are better able to provide portfolio diversification.

 Figure 2: Estimated return for core bond portfolios vs. cash has risen over the past year

2. Diversification of equity market risk

Despite their recent rise, bond yields remain structurally lower than long-term historical averages. This has caused investors to question whether bonds will still provide low or negative correlation to equities. While bonds have exhibited a fairly low or negative correlation to equities over the past 20 years, it is important to understand that over longer periods of time, bonds have not always displayed a negative correlation.

What has been shown to really matter, however, is ‘conditional correlation’ – that is, the correlation given certain market or economic conditions. For example, bonds have provided equity diversification and positive returns in nine of the 10 U.S. recessions since 1952, regardless of whether the average correlation to equities at the time was positive or negative. Importantly, government bonds have historically demonstrated a negative equity beta conditional on equity drawdowns, which implies that bond returns should increase as the size of equity drawdowns increases.

Although it’s important to acknowledge that bond yields are lower today, we still believe this diversification potential is valuable. Australian bonds have historically been one of the best diversifiers in risk-off environments, even at lower yield levels (see Figure 3). Given risk asset valuations have continued to move higher and price in a very strong global recovery, it may be prudent to have some insurance in the event that the recovery is not as strong as expected. Particularly when this insurance also pays you an estimated return above cash and term deposits. 

Figure 3: Australian bond returns in equity sell-offs

3. Diversification by risk factor not by manager is key to constructing well-diversified portfolios

Asset classes are simply carriers of risk factors. Investors are generally familiar with risk factors when it comes to equities – common risk factors include value, growth, quality, size, momentum, to name just a few. However, when it comes to fixed interest, they are less familiar with the underlying risk factors driving their portfolios.

While investors often focus on diversifying their portfolio by manager, they tend to spend less time ensuring that the risk factors adopted by managers are truly diversified in an overall portfolio context. This is a fundamental flaw since the correlation between risk factors tends to be more stable than the relationship between managers and asset classes.

With inflation expectations rising, investors may think they are doing the right thing by concentrating portfolios on floating-rate credit exposures and reducing interest rate duration within portfolios. Although on the surface these types of portfolios may look diversified, they are often heavily reliant on credit risk factors (for example, investment grade credit spreads), which are more correlated to equities compared with the interest rate duration factor, which is predominantly negatively correlated. This narrower approach to risk factors can lead to portfolios that are less resilient across a range of scenarios and environments.

It can also be easy to overlook the benefits of employing a more diversified, multi-sector approach to credit allocations. By diversifying across a wider range of risk factors than simply investment grade credit spreads – such as high yield, emerging markets, or securitised debt in different geographies – investors historically have been able to achieve better risk-adjusted returns. It also offers a larger opportunity set from a return perspective and can be a valuable complement to core holdings.

Given the recent repricing in term risk, it’s an opportune time for investors to refocus their attention on building resilient portfolios that combine a whole range of risk factors to protect portfolios against a variety of scenarios (both expected and unexpected). Focusing on greater risk factor diversification should lead to better risk-adjusted returns and more predictable outcomes in market downturns.

Bottom line: Bonds remain a key part of a diversified portfolio

One of the key reasons why many investors hold bonds in a portfolio is for their diversification and defensive benefits, to serve as a hedge against equity market sell-offs, and we expect bonds to continue to play that role. Another key benefit is income – with cash and term deposit rates remaining anchored and bond yields having risen significantly, the relative advantage of bonds has only increased. With investments in cash or term deposits, on the other hand, investors are locking in negative real returns in the current environment.

In our view, investors should save the barbells for the gym and instead focus on enhancing their risk-adjusted portfolio returns via allocations to equity-diversifying asset classes like core bonds, as well as tapping into the vast multi-sector credit universe. Those who remain wedded to cash due to fears about bonds may be doing themselves, and their investment portfolios, a disservice.

For investors interested in funds that offer risk factor diversification and take advantage of multi-sector credit opportunities, discover the PIMCO Income Fund, PIMCO Global Credit Fund and PIMCO Diversified Fixed Interest Fund.

The Author

Robert Mead

Head of Australia, Co-head of Asia-Pacific Portfolio Management

Hugh Holden

Account Manager, Global Wealth Management



PIMCO Australia Pty Ltd
ABN 54 084 280 508
AFS Licence 246862
Level 19, 5 Martin Place
Sydney, NSW 2000

PIMCO Australia Pty Ltd ABN 54 084 280 508, AFSL 246862. This publication has been prepared without taking into account the objectives, financial situation or needs of investors. Before making an investment decision, investors should obtain professional advice and consider whether the information contained herein is appropriate having regard to their objectives, financial situation and needs.

Performance results for certain charts and graphs may be limited by date ranges specified on those charts and graphs; different time periods may produce different results. Charts are provided for illustrative purposes and are not indicative of the past or future performance of any PIMCO product.

Correlation is a statistical measure of how two securities move in relation to each other. The correlation of various indexes or securities against one another or against inflation is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility.

Diversification does not ensure against losses. Duration is the measure of a bond's price sensitivity to interest rates and is expressed in years.

Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.

This presentation contains the current opinions of the manager and such opinions are subject to change without notice. This presentation has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this presentation may be reproduced in any form, or referred to in any other publication, without express written permission.

There is no guarantee that these investment strategies will work under all market conditions and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown.

All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be appropriate for all investors. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee, there is no assurance that private guarantors will meet their obligations. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Private credit and equity strategies involve a high degree of risk and prospective investors are advised that these strategies are appropriate only for persons of adequate financial means who have no need for liquidity with respect to their investment and who can bear the economic risk, including the possible complete loss, of their investment. Management risk is the risk that the investment techniques and risk analyses applied by PIMCO will not produce the desired results, and that certain policies or developments may affect the investment techniques available to PIMCO in connection with managing the strategy.

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