The 30-year bull run in government bonds is thought to have run its course, but what should high net worth investors, concerned about protecting their wealth in real terms, do?

The following article is by Christophe Donay, head of asset allocation and macro research at Pictet Wealth Management, part of Pictet, the Swiss private bank. We hope readers find these comments stimulating, and respond.

During the last 30 years, government bonds issued by developed nations, especially US Treasuries, have provided investors with the advantages of two theoretically incompatible properties for any asset class: high and risk-free returns. Yields on 10-year US Treasury bonds fell from 15.5 per cent to 1.5 per cent between 1981 and mid-2012, delivering an annualised nominal return, including coupons, of an average 9.3 per cent. The annual return only sank into negative territory in five out of the 31 years.

Regrettably, those halcyon days are over and unlikely to be repeated. According to our calculations, US Treasuries look likely to deliver an average annualised return of 3 per cent over the next ten years, including reinvesting the coupon. As a result, the investment status accorded to sovereign bonds is changing: no longer are they likely to act as risk-free generators of gains.

To start with, the chances of interest rates climbing are significantly greater than the likelihood of them moving lower as the world navigates away from the troubled waters of the sub-prime and eurozone debt systemic crises. With interest rates climbing, expected returns within the fixed income asset class will also increase. If real GDP growth stays around the 3 per cent-mark and inflation is anchored at 2 per cent, long bond yields are likely to rise quite steeply, towards 5 per cent over the years ahead.

The effect of rising rates on expected average annual returns over a 10-year horizon can already be seen. Over the last six months for example, the yield on 10-year US Treasury bonds and German Bunds respectively rose from 2.5 per cent to 2.9 per cent and from 1.6 per cent to 1.8 per cent. As a result, our 10-year average annual expected return on these instruments has slightly improved. Coupons included and reinvested rose from 2.2 per cent to 3.0 per cent and from 1.0 per cent to 1.5 per cent. Consequently, over the coming years, a gradual increase in the core government bonds asset allocation in portfolios may prove a sensible move, as its status slowly shifts from a sole risk diversifying asset towards a return delivering asset as well.  

Bonds will continue to interest investors as they retain their role in portfolio diversification. Over and above their role as diversification tools, the change in the status accorded to sovereign bonds will place asset allocators in an impossible position as they seek to reproduce the returns of the recent past.
There are, however, three main ways to compensate for the squeeze on returns from bonds in an asset allocation:

1 – making use of leverage;
2 – taking advantage of risk premiums not subject to arbitrage, such as private credit; or
3 – shortening or lengthening durations on the bond position.

The leverage route
Going down the leverage route would obviously be perilous as risks borne by the investor are invariably proportionate to the leverage being used. Moreover, recourse to leverage is out of the question if restrictions applied to investment management impose caps on weightings which asset classes must not exceed. In any event, we would neither recommend nor make use of leverage.

The second option involves exploring the full array of segments under the umbrella heading of the bonds or fixed-income asset class. One such vehicle would be private credit in order to lock on to the higher rates for borrowers and benefit from returns from arbitrage-free risk premiums. This approach is only advisable if no leverage is involved and provided there is no serious deterioration in the quality of assets held in the portfolio. This way round the original problem does have drawbacks though - the liquidity of high-yield bonds - and, by extension, private credit – is much thinner than for US or German sovereign bonds. That can lead to concealed risk in the portfolio, mounting instability in portfolio quality and heightened volatility in performance.

The third and final alternative involves shortening or lengthening durations. This approach just will not be effectual in a setting where the yield curve has a normal shape and where the policy of zero interest rates is kept in place for a lengthy period.

New thinking, combined with much more finely tuned economic and financial scenarios, will be of paramount importance. With this in mind, we have thoroughly revamped the structure of our own asset allocations in the last couple of years.

For example, although we have retained some segments of sovereign debt issued by eurozone peripheral countries in portfolios on account of the potential for their long-term interest rates to come down, US Treasuries and German Bunds, in our opinion, only merit a place for the purposes of diversifying risk. Moreover, we have pinpointed a number of fixed-income segments, such as private credit, as still offering some attractive return prospects.