Asset class behaviour has a tendency to surprise.

Few predicted a three-decade global bond rally from a traditional “safe haven” asset class that saw returns outpace shares over extended periods. While few are now predicting a crash, there exists a high degree of uncertainty given the length of the bull market in bonds and the extreme level of re-leveraging by central banks in recent years.

Ten-year U.S. Treasury note yields jumped from 1.78% in early November to 2.6% by mid-December, decimating bond prices and resulting in the most volatile year since 2013’s “taper tantrum.”

Conservative retirees who have grown accustomed to historic low interest rates are now grappling with negative returns. The SuperRatings SR25 Diversified Fixed Interest Index lost 0.99% over the three months ended December 31, 2016, and -0.06% over the six-month period (nominal–real returns were worse when adjusted for inflation).

Why the bond rally may end

Inflation and growth in developed markets have remained soft in the wake of the global financial crisis despite the supportive actions of central banks. Interest rates were slashed while quantitative easing programs scooped up trillions of dollars in bonds and other assets in an effort to stimulate economies.

It helped pump up asset prices (with occasional outbreaks of volatility), but growth and inflation remained stubbornly low. Those expectations have changed with the election of Donald Trump and his promises to cut taxes and roll out massive spending programs on infrastructure. Given the historically low rates of return and increasing threat of inflation, real returns (not nominal) are once again part of the investment conversation.

The US Federal Reserve is now expected to continue its interest rate hikes at a faster pace as the economy continues to recover. Meanwhile, there is a growing realisation that other central banks around the world may have reached the limits of monetary policy and be on the verge of slowly winding back their quantitative easing programs.

While 10-year US Treasury note yields returned to around 2.5% by February, investors are potentially facing a radically different outlook which may recast the role of bonds in a portfolio.

Rising risks include greater volatility, capital losses and less diversification benefits as higher interest rates cause revaluations of bonds and other cashflow-producing assets such as property, infrastructure and private equity.

A new way to manage bond risk

The nature of bonds is different from equities (although contrary to assumptions, bond returns aren’t always negatively correlated with equity returns). Bonds tend to exhibit lower volatility and price changes are slower moving.

Derivative-based overlays are more commonly applied to equities, but a Milliman analysis suggests that it may also be an effective strategy for bonds–particularly as we potentially enter an era of heightened risk.

An analysis employing the Milliman Capital Protection Strategy (MCPS) on the Bloomberg AusBond Composite 0+ Year Index from 2000 to 2016 shows attractive results where volatility and the severity of maximum drawdowns were both reduced.

The MCPS is a protection strategy designed to imitate the payoff of a put option by systematically controlling the bond exposure of the underlying fund. The exposure to bonds is dialled up or down depending on how much risk is present in the market as assessed by the model.

The objective is to provide an asymmetric bond returns profile such that exposure is reduced as bonds lose capital value and increased as capital values stabilise and begin rising.

As MCPS is focused on managing the downside risk of the bond portfolio, the protection benefits of the strategy is difficult to illustrate within a back test due to the historically strong performance of bonds and the lack of sustained downturn periods. In other words, it is difficult to test a strategy which provides protection from downturns when downturn experiences have been rare in the available Australian bond data history.

A separate analysis of the S&P/BGCantor Current 5 Year US Treasury Index shows similarly strong results, but with a longer data set and more downturn periods, and reveals the strategy’s performance during the substantial 1994 and 1999 downturns.

With bond markets exhibiting lower volatility than equities, the managed risk strategy has reduced maximum drawdowns by 40% to 50% with marginal performance drag.

Milliman has a long history of employing these type of derivative strategies in the equities market. We provide investment advisory, hedging and consulting services on over US$143 billion in assets (as of December 31, 2016).

This particular rules-based derivatives strategy differs from the discretionary calls of a fund manager and its performance can be modelled under different market scenarios that may occur.

Asset classes rarely behave as investors expect–this is exactly why protection strategies should be systematically applied to ensure consistent results can be achieved.

Disclaimer

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Any hypothetical, backtested data illustrated herein is for illustrative purposes only, and is not representative of any investment or product. RESULTS BASED ON SIMULATED OR HYPOTHETICAL PERFORMANCE RESULTS HAVE CERTAIN INHERENT LIMITATIONS. UNLIKE THE RESULTS SHOWN IN AN ACTUAL PERFORMANCE RECORD, THESE RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, BECAUSE THESE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THESE RESULTS MAY HAVE UNDER-OR OVER-COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED OR HYPOTHETICAL TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THESE BEING SHOWN. For any hypothetical simulations illustrated, Milliman AU does not manage, control or influence the investment decisions in the underlying portfolio. The underlying portfolio in hypothetical simulations use historically reported returns of widely known indices. In certain cases where live index history is unavailable, the index methodology provided by the index may be used to extend return history. To the extent the index providers have included fees and expenses in their returns, this information will be reflected in the hypothetical performance.