Fund managers have sold their expertise on their ability to enhance returns using a “balanced” approach in building portfolios. Familiar to all is the 60/40 split between equities and fixed income, respectively. The split offers a safeguard by preserving overall returns when bond yields drop (prices rises) in response to volatile equity markets. While managers will tweak that split, it has become the workhorse of the industry. Today’s challenges are how to preserve returns in a world of declining real interest rates-----bonds appear to be the Achilles’ heel to the average portfolio manager.

Central bankers everywhere are now admitting that bank rates will remain at these low levels indefinitely. More to the point, falling real rates of interest have dragged bond yields to their lowest levels in history. The investment world changed fundamentally after 2008 as real short- term rates dropped below zero (Figure1). Central bankers have signaled that real rates will continue below zero as the world confronts declining economic growth prospects.

Figure 1 Falling Real Rates of Interest

(Click on image to enlarge)

Source: RBC Global Asset Management, September 2020.

Fixed income asset managers now are faced with a decision to extend duration (i.e. buy longer-dated bonds) in an effort to improve overall returns. Customarily, yield curves slope upwards as investors demand higher returns for investing further out in time. This “term premium” is usually in the range of 200-300 basis points between short-term and long-term rates. But that spread has tightened considerably and to many investors, the term premium has essentially vanished. That is, bondholders do not anticipate any surge in inflation that will erode the value of their investments over time and are content with low yields.

Not all financial investors are so inclined, however. There is the search for greater yields as fund managers are encouraged to take on more risky assets such as equities and corporate bonds. But stretching for yields does not come without risks. Long-dated bonds introduce exposure to inflation down the road; corporate bonds always carry the threat of default; and, with the exception of government debt, there are risks regarding liquidity when everyone wants to exit positions at the same time during a financial crisis. So, balanced funds offer a combination of assets in the hope that the mixture will minimize risk through diversification and also enhance overall returns.

However, what investors need to appreciate is that low real rates of interest impact not only bonds but all asset classes. Low real rates are a reflection of expected slow growth and no inflation. Equities will be subject to restraints on profit margins as companies struggle to return to pre-pandemic profitability. We can expect lower returns not only on bonds but also in stocks and commodities held in multi-asset portfolios. Investors believe that they can pivot from bonds and add to their stock portfolios to escape the impact of low yields. However, they should think again about how well those stock portfolios will perform. Every asset class is subject to the same macroeconomic conditions.

No doubt balance funds will shift positions, at the margin, and slightly alter the conventional 60/40 split. We can expect many funds to try to boost incomes and generate capital gains by adding investment-grade, high-yield corporates, and possibly emerging markets’ debt. Bear in mind that:

• the spread between investment-grade corporates and Treasuries is a mere 1.5%;
• high-yield corporate spreads have fallen from 10% in March 2020 to 5% today;
• oil is well below $40/bbl and continually under pressure as oil demand falls; 
• the emerging markets debt is at great risk as those countries struggle to manage the pandemic and,
• equities are always subject to volatility, especially as the pandemic has yet to be contained.

Thus, shifting out of government bonds does introduce a set of risk elements that need to be considered before leaving government bonds.