It is vital that investors are selective when choosing bonds and funds to include in their portfolios. Not only do some bonds rise in price at the same time as others are falling, some bonds are more likely to follow the direction of the equity market than that of the bond market. This has crucial implications for portfolio diversification. 
Equity-like risk from a bond fund is fine if that’s what an investor wants but it is clear many of the more aggressive bond structures do not provide diversification from equities, and this is perhaps not fully understood by all their investors.
Many investors use bonds to diversify their portfolio risk. At times of stress, if equities and other higher risk assets are falling, bonds are believed to be a relatively stable asset class that might rise in price as riskier ones fall. This all has to do with correlation:
- Positively correlated assets move in the same direction, up or down in price as a group
- Negatively correlated assets move in the opposite direction
- Uncorrelated assets just do their own thing, regardless of market direction
Most people assume bonds and equities are negatively correlated, hence the benefit that bonds provide to portfolio diversification. But is this always the case?
For a decade, it hasn’t really mattered too much which assets you invested in. Central banks have used their authority to try to ensure most assets move in the same direction – for them, rising prices are good!
However, there is a chance that central banks will become more comfortable allowing markets to do their own thing: equities might go one way, bonds the other. And, therefore, portfolio diversification might start to matter again.
For investors, it won’t just be about how many bonds they own, it will be about which type of bonds. Extending this, the type of bond fund an investor owns will be crucial.
What is the evidence? If we look at the UK gilt market, year-to-date losses (to 31 March 2021) are around 7.5 per cent. Gilts are normally fairly stable but fears of reflation and of better-than-expected economic performance have pushed prices down. At the same time, the FTSE 100 has risen over 4 per cent – again as expected, corporate earnings rise in the ‘good times’, making equities more valuable.
Is this pattern repeated across the bond market? This is where it gets interesting – some parts of the bond market have actually risen in price year to date. In other words, they are positively correlated to equities and negatively correlated to other bonds. If your bond fund is full of these assets, then your risk is not diversified; rather it is aggregated.
The chart below shows the return for gilts and the FTSE 100. In addition, I have included three types of non-government bonds:
- high yield bonds (often decent companies, but with lots of debt)
- corporate hybrids (an amalgam of debt and equity where bond holders might not do too well if things go wrong)
- contingent capital bank debt (a type of product which is expected to make a loss in the bad times. It looks and smells like an equity but is often sold as a bond)
To no surprise, the assets that seem most equity-like have risen year-to-date following the path of the equity market. High yield has also risen because during times of rising inflation, companies with lots of debt on their balance sheet tend to do well. Hybrid debt has fallen in value, but much less so than the wider bond market.
Therefore, you really need to be careful what your bond fund owns. Very few core parts of the market have made money year to date. Those that have are often more closely correlated to equities than bonds. This is fine if the investor wants that kind of risk.
However, it is clear many of the more aggressive bond structures do not provide diversification from equities. Instead of chasing the lower reaches of the bond market, why not invest in equities as well as a core bond fund?
David Roberts is the head of the Liontrust global fixed income team. The views expressed above are his own and should not be taken as investment advice.