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The burden of bonds

The burden of bonds

Equities have historically outperformed over the long run. However, big losses often occur at bad times, affecting careers, house prices and even relationships. We can't easily diversify our jobs or homes, making it important to diversify our investment portfolio. 

Bonds have been the natural choice, given they provide income and diversification. Indeed, the adverse effect of lower interest rates was made up by the growing hedging benefits of bonds. Notably, the correlation between stock and bond price moves has turned increasingly negative over the last 25 years.

This offsetting relationship is valuable. In practice, a bond buyer receives an equity put option in addition to interest payments. When stocks have fallen sharply, bonds have risen. We estimated the value of this embedded option using observed bond moves during stock market sell-offs.

“This offsetting relationship is valuable. In practice, a bond buyer receives an equity put option in addition to interest payments. When stocks have fallen sharply, bonds have risen. We estimated the value of this embedded option using observed bond moves during stock market sell-offs”

 

As a result, we estimate that replicating the implicit hedge provided by Treasuries held in a 50% stock and 50% bond portfolio through S&P 500 put options would have otherwise cost around 2.5% per year.

Bondholders not only received a decent coupon — the 10-year yield has averaged 3.75% since 1995 — but also got “free” protection against stock market drops. Historically, during corrections, bond gains offset approximately 40% of concurrent equity losses.

 

Why diversify equities

However, during the drawdown earlier this year, between 19 February and 23 March, 10-year Treasuries returned 7%, while the S&P 500 dropped 34%. Treasuries hedged only about 20% of the equity drop, as low starting yields in February reduced the upside from the bond rally.

Bonds are mathematically much less attractive now with the 10-year yield at 0.55%, reducing both income and upside. Barring negative rates, we estimate the embedded put option is only worth about 1% per year, even if the stock and bond correlation stays quite negative. The yield and diversification benefits of bonds have shrunk, while the risks of higher rates or correlations have risen.

“Diversifying with equities not only reduces portfolio risk, but many other risks that an investor faces”

 

Instead of relying primarily on bonds, investors should add absolute return strategies or other investments that are uncorrelated to stocks, both in theory and in practice. Diversifying with equities not only reduces portfolio risk, but many other risks that an investor faces.  

 

Bio

Aneet Chachra and Steve Cain are both portfolio managers at Janus Henderson Investors. Before Chachra joined the firm in 2012, he was an equity analyst at Citigroup and a strategist at Outpost Investment Group. Cain has been at the firm since 2010 and previously founded Kurtosis Capital Partners and Nylon Capital.  

Disclaimer Past performance is not a reliable indicator of future results.

CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.

The material has not been prepared in accordance with legal requirements designed to promote the independence of investment research. Although we are not specifically prevented from dealing before providing this material, we do not seek to take advantage of the material prior to its dissemination.

CMC Markets does not endorse or offer opinion on the trading strategies used by the author. Their trading strategies do not guarantee any return and CMC Markets shall not be held responsible for any loss that you may incur, either directly or indirectly, arising from any investment based on any information contained herein.

*Tax treatment depends on individual circumstances and can change or may differ in a jurisdiction other than the UK.

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