How will bond portfolios react if the US election triggers further market mayhem? Fallout from Brexit taught us valuable lessons about extreme market shocks.
Bond markets are still digesting the full implications of the Brexit vote. But it’s already revealed key insights into building more volatility-proof portfolios.
LESSON 1: DIVERSIFICATION DELIVERS
Benchmark-driven bond investing forces investors to back only one specific part of the bond universe—so it can really hurt if these bonds lag. But active bond funds can hold many different kinds of eggs across many different baskets and, together, they can help keep risks in check.
The Brexit vote proved a decisive vindication of the benefits of building a well-diversified set of bond exposures and being skeptical when financial markets take a consensus view.
Before the vote, markets were behaving as if the UK had decided to remain. The British pound and UK equity markets were making gains and UK government bonds (gilts) were selling off. Stepping away from the crowd and buying into gilts at attractively cheap prices ahead of the vote proved highly beneficial.
LESSON 2: SEEK SAFE HAVENS WITH DECENT YIELDS
“Safe-haven” bonds—the highest quality government debt—are expected to hold on to, or increase, their value when other assets sell off. But bonds with yields below 1% are much less effective at absorbing market shocks. Their yields simply can’t fall much more, so their prices can’t rise meaningfully, when riskier assets sell off.
After the Brexit vote, government bonds with decent yield buffers—gilts, Australian and Canadian government bonds and US Treasuries—significantly outperformed their counterparts with ultra-low and negative yields, like German Bunds and Japanese Government Bonds (JGBs).
The compression of safe-haven bond yields is also enhancing the appeal of safe-haven currencies as effective shock absorbers. During Brexit-driven turbulence, the value of safe-haven currencies like the Japanese yen and the Swiss franc rose more than the value of either JGBs or Swiss government bonds.