Sovereign bonds have long been the prime defensive asset for multi-asset portfolios. But in today’s extraordinary market conditions, should investors make more extensive use of other defensive choices?

Multi-asset investors have always been able to access a full toolkit of investment strategies to help reduce downside risk. Over the last four decades, though, they haven’t had to look any further than developed-market (DM) sovereign bonds, which have been the ideal portfolio diversifier, providing reliable protection, deep liquidity and meaningful income simultaneously. Even over the last decade of meagre yields, the defensiveness of sovereign bonds has been impressive. For multi-asset investors, using sovereign bonds was like buying insurance for the portfolio but getting paid a premium for it.

Going forward, however, this windfall from sovereign bonds is unlikely to be as bountiful. Multi-asset investors will likely have to make more flexible and comprehensive use of their defensive toolkit than they have in the past.

Sovereign Bond Returns May Be More Muted in a Policy-Constrained Era

Several factors have eroded the payoffs for investing in sovereign bonds and may moderate their defensive characteristics in the future.

First, record low or negative yields have limited income potential. Investing in longer-dated sovereign bonds might not do much to address this problem, as yield curves are no longer reliably steep. As developed-world governments become more indebted, they may increasingly resort to yield-curve control strategies to contain their borrowing costs. So the opportunities for investors to benefit from roll-down strategies to generate return will probably be more constrained, in our view.

With yields already at such low levels, and as policymakers face constraints on their ability to cut rates further, we believe that sovereign bonds won’t protect so strongly when equity markets struggle. Although they may still be helpful in diversifying a multi-asset portfolio, the extent of their payoffs during market setbacks may be more modest.

In fact, this shift is already happening (Display, below). Sovereign bonds with yields close to zero and/or from policy-constrained issuers didn’t provide as much diversification benefit during the COVID-19 sell-off as in previous years.

From 2010 to 2017, during equity sell-offs of 10% or larger, the sovereign bonds of countries with monetary space (comprising the US and the UK) returned 2.32%, whereas countries at or near their policy floor (comprising Germany and Japan) returned less than 0.99%. But from January 2018 through March 2020, the respective returns were 2.25% for US/UK versus just 0.11% for Germany/Japan.

Following the emergency measures sparked by the COVID-19 crisis, fewer sovereigns are likely to have headroom for significant rate cuts and/or major additional monetary stimulus. So the background for sovereign-bond performance may be even more challenging in the future. This reinforces our conviction that both the return and diversification properties of sovereign bonds are likely to be lower than they’ve been over the last four decades.

But that’s not all. Evidence of the reversal of globalization and the potential for monetization of elevated government debt levels threaten an end to secular disinflation trends. And the potential for a return to an inflationary regime reinforces the need for a diversifying set of defensive strategies over a longer-term horizon.