Diversifying against equities while bonds are yielding ~zero and reserve banks are printing extreme amounts of money?12 Jul 2020
My Sunday night thoughts on the topic.
I was wondering if there isn’t an alternative to nominal bonds for diversifying against downturns in equities, that also gives protection against inflation1. Since nominal bond yields across developed economies are now so close to zero, coupled with ongoing extreme amounts of money printing by central banks to combat the covid19-related economic slowdown, there is limited upside left in holding the large exposure to nominal bonds outlined in our previous portfolios2.
So I asked the question, could I replace some (or all) of our nominal bonds with Inflation Linked (IL) bonds, while still holding a balanced asset mix diversified across currencies, geographies and asset classes?
My analysis found that the simplest way to deal with this was to keep my equities, commodities, gold and emerging markets target weights as they are, and simply switch nominal bonds to IL bonds instead. I thought of this idea after watching this video from Bridgewater. The whole video is excellent, but the last few mins (from around 27:45 onwards) lay out my motivations, succinctly.
I ran historic data through my volatility budgeting algorithm to figure out the new weights needed to do this and still keep the whole portfolio balanced in line with the all-weather principle. Interestingly the asset class weights come out neatly such that all that is required for this tactical change is to switch some (or all) nominal bonds to IL bonds. All other assets’ weights could stay basically as they were. The resulting asset mix could look very much like that in Table 1.
Table 1. A global ESG filtered all-weather portfolio that uses inflation linked (IL) bonds in place of nominal bonds3
|Ticker||Portfolio Weight||Asset Class||Region||Exchange|
|VESG||18%||Equities||International (Developed Markets)||ASX|
|VGE||2.5%||Equities||International (Emerging Markets)||ASX|
|WIP||10%||Inflation linked Government Bonds||International (Developed Markets) Ex. US||NYSE|
|SCHP||20%||Inflation linked Government Bonds||US||NYSE|
|ILB||7%||Inflation linked Government Bonds||Australian||ASX|
|GSBE47||4%||Government Bonds (long term)||Australian||ASX|
|GGOV||10%||Government Bonds (long term)||International (Developed Markets)||ASX|
|IHEB||6.5%||Emerging Market Credit||International (Emerging Markets)||ASX|
1 Previously, when equity markets have dropped, central banks have lowered interest rates to stimulate their economies, thus driving up bond prices which has counterbalanced the short-term downturn in equities to smooth out the ride in our volatility balanced portfolio. But now that interest rates are basically at 0%, this once trusty simulative lever of lowering interest rates is no longer going to be effective to offset drops in equity markets. So, what do we expect countries to do next time equity markets drop? For one thing, monetary policy is likely to get more extreme in terms of printing money. This extreme increase in money printing brings another risk for anybody holding large % of nominal bonds – inflation. Since bonds hold a promise to pay back their face value in cash, high inflation rates erode the purchasing power of cash and thus decrease the value of nominal bonds. IL Bonds correct for this, by increasing face value in line with inflation.
2 Amy and I made a number of posts since our August 2019 blog outlining a defensive portfolio to weather economic storms. The follow-up posts in April 2020, after the market shocks caused by COVID 19, showed that both the original solution and our evolved solution of an Environmental, Social, and Governance (ESG) filtered version of this strategy performed exactly as designed and weathered the COVID 19 market storms well, for which we were very happy and grateful.
3 There is currently no way to get global IL bond exposure via the ASX, so we use TIP and WIP via the NYSE for our global IL bond exposure. Access to the NYSE also means we can use DBC for commodities exposure which we like since this ETF is far more liquid than the commodities ETF available on the ASX, ‘QCB’, which has very low trading volume leading to liquidity risk.