Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Bitcoin, gold, and VIX are worth considering in flat yield environment
Peter Garnry
Chief Investment Strategist
Summary: In today's equity update we take a look at yesterday's price action and show how government bonds were flat as a pancake offering no help to portfolios bleeding from declines in equities. Going forward with higher policy uncertainty, inflation and low interest rates, long volatility will likely be a crucial component to bolster risk-adjusted returns. We take a look at how to do this but also at other alternatives such as gold and Bitcoin which are worth considering in a prolonged inflationary environment with deep negative real rates.
Much has been written already about the death of the 60/40 portfolio and we have also talked about it on our daily morning podcast and on our Special Edition post from March 25 called Roundtable on the crisis and its aftermath where our CIO Steen Jakobsen talks about the need for long volatility components in portfolio construction.
Low interest rates
Central banks around the world have doubled down on their monetary policy since the Great Financial Crisis pushing down rates again and substantially increased their asset purchase programmes. In their forward communication with the market rates will stay compressed for a long time as the global economy will take time to heal from the Covid-19 induced economic crisis. The latest strategy change is the concept of average inflation targeting which means that the Fed will allow inflation to overshoot and thus accepting deep real negative interest rates. A potential next step in this logic is the concept of yield curve control in the case the bond market pushes up interest rates on inflation or fiscal deficit worries.
Overall, it is reasonable to assume that expected returns on government bonds will be close to zero for many years. One thing is the low expected returns, but what is more frightening is what we saw yesterday where governments bonds offer limited negative covariance to equities when we have a tail-risk event (a large daily negative return in equities). In most crisis events since 2008 the long end of the government yield curve has provided that, but no longer. The chart below shows how European government bonds were flat as a pancake. Only long volatility expressed through long VIX futures provided protection. Our view is that there will be a historic rotation in asset allocation strategies and the hedging and derivatives strategies will be reborn to accommodate portfolio managers.
In one of our recent Saxo Thought Starters piece Limiting drawdowns by adding volatility exposure to your portfolio we show how just a 4% allocation to long volatility reduces drawdowns without sacrificing too much on returns. Historically a long volatility position continuously rolled had large negative carry because the VIX future curve most of time is in contango; in other words, you pay a premium for long volatility expectation that never materialises. Now as government bond yields have gone to zero or in some cases negative, the spread to the negative carry on long volatility makes the long volatility component much more attractive and feasible on a relative basis. We would go as far as recommending investors to replace most of their government bond holdings with investment-grade corporate bonds. Because if you are not getting any future returns and there is no negative covariance during tails why not go a bit further out on the bond risk curve and get a bit more yield and offset the higher risk by adding long volatility?
For European investors the Lyxor S&P 500 VIX Futures Enhanced Roll UCITS ETF (VOOL:xetr) is the only easily accessible ETF to get this exposure. Managing and rolling VIX futures are not something we recommend for the ordinary retail investor. An alternative for those investors that can invest in non UCITS funds the iPath S&P 500 Dynamic VIX ETN is worth considering. As the chart below shows the dynamic VIX ETN manages the negative carry from the VIX curve contango much better than the UCITS fund which means that a larger exposure can be allocated to this VIX fund to offset tail-risk events in equities. We know it is complex and out of reach for many retail investors, but we are in a new environment and all investors should think about how to protect wealth and construct meaningful portfolios in a flat yield environment.
Inflation and debasement introduce new risks
Low yield environment and the lack of negative covariance from government bonds during tail-risk events in equities is one key risk going forward for portfolio that we have discussed, but the next big risk source will come from inflation. Yesterday, our colleagues Ole S. Hansen, Althea Spinozzi, and Christopher Dembik held a webinar on inflation called Everything you need to know and how to hedge against it; you find on the previous webinars page.
Many traditional things such as inflation-linked bonds and gold makes sense in an inflationary environment because their value historically is protected from inflation. Gold has that other advantage that sometimes it adds good hedging during tail-risk events in equities such as the period 19 February to 23 March this year (see correlation matrix). A third option against debasement is the digital currency Bitcoin which could become more attractive in a prolonged inflationary environment. All these components that we have described are components that investors should consider and in our next Quarterly Outlook we will focus more intensively on asset allocation in this new regime post Covid-19.
Appendix
5-year chart on the STOXX Europe 600 Index, Lyxor S&P 500 VIX Futures Enhanced Roll UCITS ETF, and iShares Core EUR Govt Bond UCITS ETF
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