Recent events in the UK are a reminder of the benefit of a globally diversified sovereign bond allocation and avoiding home bias, as Jennie Byun, Kurt Knowlson and Steve Ryder explain.
Read this article to understand:
- Why recent events in the UK highlight the risks of having a home bias in portfolios
- The advantages of a global approach to government bonds
- How the empirical evidence for diversification stacks up over different timeframes
Developed sovereign bond markets have suffered steep falls this year as central banks responded to soaring inflation with aggressive monetary tightening. Investors have had few places to hide, with the surge in yields in turn prompting steep falls in riskier asset prices.
Nonetheless, government bonds remain an important building block for client portfolios given their liquidity, end investors’ familiarity with them, and the fact that over longer timeframes they have been the most reliable way of diversifying equity risk. Moreover, given how far yields have risen, government bonds arguably offer better value than at the start of the year.
For investors considering allocating to the asset class, the key decision is which markets to invest in. Familiarity might lead many to favour bonds issued by their domestic government. However, with markets on the lookout for any signs of fiscal vulnerability as the era of cheap money comes to an end, such an approach can be dangerous.
Risks of a home bias
Recent events in the UK gilt market offer a cautionary tale. Bond prices and sterling plummeted after the government unveiled the biggest tax cuts in half a century on September 23, on top of a huge package of energy subsidies, both of which were unfunded. Although the violent market reaction forced the government to perform a swift U-turn, confidence in the UK macroeconomic policy framework has been dented. It will be hard to repair, even with a new prime minister on board.
Investors with a home bias to UK government bonds have been hit especially hard
While the plunge in gilts occurred against a backdrop of a global bond market sell off, investors with a home bias to UK government bonds as part of their strategic asset allocation have been hit especially hard. Figure 1 shows the extent to which UK ten-year bonds underperformed their US and German equivalents.
Figure 1: Gilt spreads surge (per cent)
Source: Aviva Investors, Bloomberg. Data as of October 14, 2022
To mitigate risk, investors in the UK and elsewhere with an allocation to domestic sovereign bonds should consider shifting their exposure to a global fund. As the era of cheap money comes to an end, there is every chance bond markets will put far greater emphasis on economic fundamentals. Since economies operate on different cycles, driven by idiosyncratic factors, that could lead to greater divergence of returns, enhancing the benefits of diversification.
Aviva Investors’ multi-asset portfolios adopt a global approach to sovereign fixed-income allocation. Aside from reducing exposure to idiosyncratic UK events, this approach helped lower the duration of the funds’ sovereign exposure. It also offered more risk-reducing potential during periods of market stress, given the higher exposure to US Treasuries, the ultimate safe haven.
Shifting allocation has provided benefits to performance
Shifting allocation has also provided benefits to performance. The Global Sovereign Bond index has delivered an annualised return of -0.8 per cent over the past five years, compared with a loss of -3.5 per cent from gilts.
While past performance does not reliably predict future results, the benefits of avoiding concentration in any one idiosyncratic risk by taking a global approach seem likely to persist. Figure 2 shows the best and worst-performing sovereign markets within the Bloomberg Global Aggregate Treasury index over the past decade. In each of the past ten years, there has been a wide variability between the best and worst-performing markets; no one country has consistently performed best or worst.
Figure 2: Global Investment Bond best versus worst performers (annual total returns per cent)
Note: We take the best and worst calendar year returns across 36 single-country Bloomberg government bond total return indices denominated in each country’s currency.
Source: Aviva Investors, Bloomberg. Data as of June 2022
We also evaluate the diversification benefits across different timeframes. By taking a global approach, investors have historically been able to achieve superior risk-adjusted performance over multiple timeframes, with very few exceptions, compared with allocating to a single-currency benchmark.
The global portfolio shows strong diversification benefits without sacrificing returns
Figure 3 evaluates the risk and return profiles of individual sovereign markets and the global sovereign benchmark over time. We see the global portfolio shows strong diversification benefits without sacrificing returns across all time periods. While the global benchmark has delivered a negative annualised return over the past three and five years, that is unsurprising given the sell-off across nearly all markets.
Its risk-adjusted performance compares favourably with all other markets except for Japan, where the Bank of Japan’s yield curve control has prevented yields from rising since its introduction in September 2016. Equally, however, this limits any upside potential on Japanese bonds moving forward.
A similar story unfolds when looking at longer timeframes. For example, although the Spanish and Italian markets have delivered stronger annualised returns over ten and 15 years, this has come with significantly higher volatility. Moreover, the strong returns generated by these two outliers is explained by the starting point being the peak of the European sovereign debt crisis.
Figure 3: Investment grade sovereigns versus global benchmark – efficient frontier (per cent)
Note: Annualised return calculated using weekly prices. Standard deviation is the annualised standard deviation of logarithmic weekly returns. The World portfolio is represented by the Bloomberg Global Aggregate Treasuries Total Return Index Hedged GBP. Individual country portfolios use the Bloomberg U.S. Treasury Total Return Index Hedged GBP and the Bloomberg Global Total Return indices for each respective country, hedged to GBP.
Source: Bloomberg, calculations by Aviva Investors. Data as of September 30, 2022
No free lunch?
As Harry Markowitz, the founder of modern portfolio theory, once famously said, when it comes to investing, “diversification is the only free lunch”. In that spirit, a properly diversified portfolio that spreads risk both between and within asset classes should be less exposed to idiosyncratic market shocks.
Investors should consider removing any home bias in their bond allocation and instead have exposure to a range of markets.