Government bonds come close to the ideal complement for equities in a balanced portfolio. They provide both a steady income and the potential for capital appreciation at times when equities might be stumbling. Indeed few, if any, other assets provide this sort of diversification benefit. However, with gilts currently trading on such paltry yields, managers of balanced portfolios have been left in a quandary, since UK government bonds now provide little in the way of income and scant potential for capital return if the economy slumps.
We estimate that 10 year gilt yields need to be close to 2% to ensure that they will buttress a portfolio meaningfully in the event of a recession. Of course, we could look to the more sensitive longer dated issues, however, these bonds are extremely vulnerable to any revival in inflation and so compounds the asymmetric risks inherent in such rich valuations.
A neat alternative approach might be to take a currency hedged position in higher yielding US Treasury bonds. Global equities would almost certainly tailspin if the US economy hit a soft patch, and with treasuries currently yielding around 3%, there is potential for significant double-digit gains should the economy tank. Sadly, for UK investors, higher US rates are unlikely to translate into a higher income yield for sterling investors once the cost of currency hedging is factored in.
However, such a strategy does come with risks. Inflation is lethal for conventional bonds especially when yields are so low. Whilst some are claiming that the Phillips Curve is dead, we are far from sure. US unemployment levels are at a level not seen in the last 50 years and with aggressive fiscal policy in place, the risks of an inflation revival is escalating. Hence this is not a strategy that we are about to hurry into, however, it is an idea that could be borne in mind if the growth outlook deteriorates markedly.
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