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.

Go global

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)
Sovereign bond risk and return 3-year return
Sovereign bond risk and return 5-year return
Sovereign bond risk and return 10-year return
Sovereign bond risk and return 15-year return
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.

Related views

Important information

THIS IS A MARKETING COMMUNICATION

Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL). Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. Some data shown are hypothetical or projected and may not come to pass as stated due to changes in market conditions and are not guarantees of future outcomes. This material is not a recommendation to sell or purchase any investment.

The information contained herein is for general guidance only. It is the responsibility of any person or persons in possession of this information to inform themselves of, and to observe, all applicable laws and regulations of any relevant jurisdiction. The information contained herein does not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorised or to any person to whom it would be unlawful to make such offer or solicitation.

In Europe, this document is issued by Aviva Investors Luxembourg S.A. Registered Office: 2 rue du Fort Bourbon, 1st Floor, 1249 Luxembourg. Supervised by Commission de Surveillance du Secteur Financier. An Aviva company. In the UK, this document is by Aviva Investors Global Services Limited. Registered in England No. 1151805. Registered Office: St Helens, 1 Undershaft, London EC3P 3DQ. Authorised and regulated by the Financial Conduct Authority. Firm Reference No. 119178. In Switzerland, this document is issued by Aviva Investors Schweiz GmbH.

In Singapore, this material is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited (AIAPL) for distribution to institutional investors only. Please note that AIAPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIAPL in respect of any matters arising from, or in connection with, this material. AIAPL, a company incorporated under the laws of Singapore with registration number 200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and Asian Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 1 Raffles Quay, #27-13 South Tower, Singapore 048583.

In Australia, this material is being circulated by way of an arrangement with Aviva Investors Pacific Pty Ltd (AIPPL) for distribution to wholesale investors only. Please note that AIPPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIPPL in respect of any matters arising from, or in connection with, this material. AIPPL, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business address: Level 27, 101 Collins Street, Melbourne, VIC 3000, Australia.

The name “Aviva Investors” as used in this material refers to the global organization of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva investors’ affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom.

Aviva Investors Canada, Inc. (“AIC”) is located in Toronto and is based within the North American region of the global organization of affiliated asset management businesses operating under the Aviva Investors name. AIC is registered with the Ontario Securities Commission as a commodity trading manager, exempt market dealer, portfolio manager and investment fund manager. AIC is also registered as an exempt market dealer and portfolio manager in each province of Canada and may also be registered as an investment fund manager in certain other applicable provinces.

Aviva Investors Americas LLC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aviva Investors Americas is also a commodity trading advisor (“CTA”) registered with the Commodity Futures Trading Commission (“CFTC”) and is a member of the National Futures Association (“NFA”). AIA’s Form ADV Part 2A, which provides background information about the firm and its business practices, is available upon written request to: Compliance Department, 225 West Wacker Drive, Suite 2250, Chicago, IL 60606.