Should private banks have a licence to kill off bonds?

While the vibrant stockmarkets of 2019 saw a 28 per cent surge in shares included in the MSCI World Index, the most dramatic activity was saved for fixed income investments.

Morningstar data shows investors, fearing a scalding from the froth of this seething equity cauldron, stashed more than $700bn in safety-first funds buying into key bond bourses.

But in more recent conversations with private bankers, high net worth investors are beginning to question why it is necessary to buy so many bonds, many of which are producing negative yields on maturity. Indeed, why are so many advisers still directing them into instruments that destroy the value created by the equity components in their portfolios?

Some asset managers – take French house Carmignac for instance – are holding between 25 to 30 per cent of their fixed income portfolios in cash to reduce risk. Apart from financial services debt, argues the Paris house, most corporate bonds are far too expensive to buy.

For clients of private banks, bonds were always at the centre of the portfolio and typically made up the lion’s share. Twenty years ago, UBS and Credit Suisse ridiculed any move to alternatives and pumped more than 60 per cent of portfolios into predominantly sovereign paper.

This dynamic has changed, argue JP Morgan Asset Management strategists in a white paper, titled ‘Rethinking safe haven assets’. Traditionally, bonds played the anchor role in private – as well as institutional – portfolios, requiring weightings big enough and of high enough quality to both dampen equity risk and generate reliable yields.

While the new wave of monetary policies triggered by the global financial crisis may have destroyed the old certainties, it took another decade for negative yields to embrace a major chunk of developed sovereign bond markets. Bonds can still be strong diversifiers, according to JP Morgan, but expecting both protection and coupons can prove a tall order.

The regional head of European private banking for one of the major global players lays down the stark decision facing the bank’s relationship managers and their clients: “The reality is, when government bonds are yielding negative rates, you have to question: ‘Does it make sense to allocate money to an instrument which is no longer a risk-free asset?”

Moreover, this changed environment means not just diversification into uncorrelated areas such as real estate and infrastructure, but more selective fixed income trades, rather than the indiscriminate bulk-buying of bonds.

Active asset managers including Franklin Templeton and Liontrust talk about using equity-style selection procedures today when buying corporate bonds, requiring forensic research of balance sheets, industry sectors and regulations. High yield, possibly the segment of bonds which behaves most like its equity counterparts, is seen by some commentators as the most attractive prospect, at a time when many clients are asking their bankers whether it makes any sense to hold bonds.

Malik Sarwar, a former senior private banking boss with HSBC, Citi and Merrill Lynch, now working as a leadership consultant, says banks must innovate more to satisfy yield-hungry clients.

This means developing data expertise and methodology to generate higher performance from factor-based models, which have proved popular in equities, but are yet to make a dent in fixed income. Green and socially responsible bonds will also become increasingly appealing to millennials. 

That said, Mr Sarwar, and others of his ilk, are not afraid to countenance what would have once been seen as the ultimate heresy of the portfolio manager – that bonds can be replaced. The historic role which fixed income has played, offering a low correlation to equities plus decent yields, has been vastly diluted, runs his argument.

Clients looking to modify asset allocations to achieve long-term goals can now look to add blue-chip, high dividend equities, suggests Mr Sarwar. 

Citi, which points to the $14tn of bonds with negative yields currently represented in global indices, is a prime example of a private bank recommending clients rebalance their portfolios. It suggests replacing some bond exposure with a combination of high dividend-yielding equities, structured products and UK commercial real estate. The latter offers yields of up to 5 per cent, double if leveraged. “It is difficult to get that type of return in a bond-like scenario anywhere in the OECD,” comments Luigi Pigorini, head of Citi Private Bank for the Emea region.

This new thinking flies in the face of the Capital Asset Pricing Model, developed by a cohort of eminent US academics in the early 1960s, adding to the foundations of “modern” portfolio theory and philosophy around diversification of assets, previously pioneered by Harry Markowitz.

The received wisdom for nearly half a century was that bonds were the natural complement for equities in “balanced” portfolios, with long-dated government bond yields roughly matching nominal economic growth.

James Bevan, head of investments at CCLA, identifies “deep conceptual flaws” to the old school approach, ready to be “cruelly exposed” in years to come. “Bonds no longer offer a risk-free return, rather they offer return-free risk,” he says, claiming diversification benefits predicated on analyses of historic returns have proved illusory.

It is fair for us to ask whether we should now abandon these old approaches. It is prudent to think more carefully about how to achieve returns, embracing not just public equities, but private equity and real estate.

Bonds will still have a clear role to play in institutional portfolios, obligated to meet liabilities, which they need their assets to serve.

But when it comes to private portfolios, the role of fixed income as the anchor or the protected core must finally be up for reassessment. It will still be important as an alpha-generator, especially in high yield and emerging market sectors, where selection will become an increasingly specialised and value-adding process.

However, the new role of central banks – and the politicians which influence them – has ensured the humble bond is unlikely to be seen in the same light again.