High allocations to bonds risk upsetting the balance

In the UK a typical ‘balanced fund’ can invest up to 85 per cent of its assets in equities. Currently, the average equity exposure of these funds stands at almost 70 per cent. While this may be the norm in the UK, to most European-based investors this will not appear to be balanced at all. They tend to have less equities and more fixed income in their balanced portfolios.

However, as yields and therefore expected returns can fall, a large allocation to fixed income can cause a dilemma. In exploring issues related to global bond funds in particular – such as product complexity, performance and correlation – it appears difficult to justify the inclusion of a large bond allocation in a typical client portfolio.

The risk is that falling yields and expected returns from traditional buy and hold investment approaches will force many bond managers to seek returns in different ways. This can lead to unintended risks and return profiles which can be different to what one would expect from a fixed income investment. For example, many global bond funds can be more akin to currency funds than traditional fixed income funds. This is because they invest in bonds which can be denominated in different currencies. Others are more similar to hedge funds and should be considered ‘alternatives’ rather than fixed income and some have significant allocations to emerging market debt.

Hard to understand

The compression in yields and the need to enhance returns has led to an explosion in complexity of bond funds. This complexity might not yet be fully recognised by the professional fund selection community, which will need to dedicate more and more resources to this area. It will also make it increasingly difficult for retail clients to understand what they are buying and they will need assistance.

In addition, a company will generally only have one ticker and one share price but there can be hundreds of different bonds, all with different prices and risks. The large number of different instruments and prices, coupled with the extensive use of derivatives, makes holdings-based analysis much more difficult.

It is vital to understand the role of currency in global bond portfolios. Whether this should be hedged into the base currency of a portfolio or not is the first question any investor should address and answer. There are 321 funds in the Morningstar category ‘Europe Global Bond’, some 111 with the euro as their base currency and 96 US dollars. Investors can also search for euro-biased or hedged global bond funds, adding a further 284 funds to the universe.

Investors also need to recognise an “asymmetrical pay off” when it comes to bond investments in general. Unlike with equity investments, the potential return investors can make on a bond is capped due to predetermined price and coupon payments, assuming nothing goes wrong. When things do go wrong, however, the investor’s loss can be as much as the loss experienced by equity investors.

We took a look at performance data for last year. From the above mentioned second universe of 284 funds, we were able to identify 245 funds with a full year’s performance data for 2011. Of these only 41 per cent (101) managed not to lose money last year while 12 per cent of them actually lost more than the MSCI World. In 2011 the top performing Global Bond Fund (euro hedged or biased) returned almost 10 per cent while the bottom fund lost almost 15 per cent. This may not be what investors would have expected from a global bond allocation.

The myriad of different global bond funds presents fund selectors with both opportunities and risks. In some cases bond funds will actually contribute to portfolio risk and in other cases, they can reduce it. The correlation table below shows the impact of using a euro hedged global bond in a portfolio with European equities. The relatively high correlations in some cases may surprise some. High correlation can present a risk because in a market downturn, investments – both bonds or equities –could potentially lose an equal amount of money.

Investors should ask themselves what role they want bonds to play in their portfolios. Diversification or risk-seeking? In either case, investors need to be cognisant of the increasing complexity and risks in this sector.

Peter Fitzgerald is senior portfolio manager, multi-asset multi-manager, at Aviva Investors