Eran Peleg, CIO
The Name is Bond…
Eran Peleg, CIO March 8, 2018
The word ‘bond’ reflects binding security, firm assurance.
For this reason, Dictum Meum Pactum (‘My Word is my Bond’ in Latin) was historically the motto of the City of London, the capital’s financial center. The Latin expression appears on the London Stock Exchange’s coat of arms. It originates from back in the days where financial transactions were made with no written pledges, no documents, and no contracts.
The financial instrument ‘bond’, an instrument of indebtedness, is normally considered to be a safe, secure, low-risk investment – especially if it is issued by a highly-rated borrower.
In addition to being considered as lower-risk investments, bonds have historically also played an important role in investment portfolio construction. They have often been a safe-haven at times of financial market stress. During these periods, as prices of higher-risk securities, such as equities, dropped, investors looking for safety pushed up bond prices – providing an offset against equity losses. Investors therefore incorporated bonds into their broad portfolios with a view that they act as portfolio diversifiers. This role is now being challenged.
Due to a prolonged period of zero interest rates and continuous buying of bonds by central banks globally, bonds yields are low (and their prices, inversely-related to yields, are high). This limits the upside for bond prices. Furthermore, given where we are in the economic cycle (advanced), long-term interest rate cycle (low and rising rates), and increasing US Treasury bond issuance (especially given the now-expected future US fiscal deficits), financial market sell-offs, like the one we just experienced, may actually be driven by expectations of increasing interest-rates – which are negative for both equities and bonds (as the cash-flows they are expected to generate are then discounted back to the present at higher rates).
It is therefore no surprise that in the February sell-off, the short-term correlation between bonds and equites turned positive, with their prices dropping in tandem. In the US market, for example, equities (S&P 500 index) fell by -3.7% and USD investment-grade bonds (Barclays US Aggregate Bond index) returned -0.9%.
Investors may need to rethink their approaches to portfolio construction and diversification.