Navigating volatile markets: harnessing the bond-equity partnership

In this article, we take a closer look at the longer-term relationship between bonds and equities, and how we can use it to our advantage during periods of market volatility.

Understanding market volatility

Financial markets never stay still and can often move dramatically higher or lower in response to major global events or when economic uncertainty arises. These events can spur markets to move sharply, creating ‘market volatility’.

When market volatility arises, it is natural to be concerned about your portfolio’s resilience. You may feel a sense of urgency to halt losses during downturns or to capitalise on gains during market upswings by moving investments into cash. However, history suggests that attempting to ‘time the market’ by withdrawing and reinvesting later typically results in lower long-term returns.

What does that mean for investments?

The good news is that not all investment categories or ‘asset classes’ react similarly in a multi-asset portfolio. There is no guarantee that the investments that perform well one year will perform well the next. Portfolio managers can exploit these differences and reduce overall portfolio volatility by selectively allocating between different financial market segments. By constructing a diversified portfolio that spans various geographies, asset classes, and sectors, investors can balance risk and return, potentially cushioning the impact of market volatility over the long term.

Combining bonds with equities

Equities (investments in a company) and bonds (investments in the debt of a company or government) are two of the most popular asset classes. They are often combined to form a well-diversified portfolio.

Equities generally provide higher returns over the longer term than bonds but also carry higher levels of risk. While bonds appear more complex than equities, they are considered less risky because they provide a regular income and a predetermined return on investment over a specific horizon. History has shown that bonds typically function as a cushion during market stress and can serve as a pressure-release valve for investors fleeing from the equity market.

Traditionally, a portfolio combines equities, bonds, and cash. Depending on risk tolerance, the mix of assets can be extended to include allocations to alternative investments such as hedge funds, real estate, infrastructure, or commodities. Constructing a portfolio with different asset types is called ‘asset allocation’.

Market stress can affect the bond-equity relationship

The relationship between bonds and equities is not always perfect. Since the Global Financial Crisis of 2007-2008, central banks worldwide have distorted bond markets by buying government bonds regardless of yield and increasing prices.

While these central bank’s ‘quantitative easing’ measures may have helped rescue the broader global economy, they blurred the relationship between bonds and equities. While still out of the ordinary, bond and equity prices can often move in the same direction, which is called a positive correlation.

This correlation can also be true in times of severe market stress when markets believe that the risks of buying bonds have increased enough to align more with equities’ risks. However, history shows this correlation often snaps back quickly when it reaches extreme levels.

The art of asset allocation

Adopting a systematic approach to asset allocation is key to making informed adjustments in response to changing market conditions. It is crucial to remain objective and not be swayed by short-term performance, whether it’s the allure of gains or the fear of losses.

When markets are judged overly optimistic, equities’ valuations can move up to levels that are harder to justify. At times like this, there is an opportunity to rebalance away from equities and selectively add to bonds. Similar to equities, bond prices move up and down in response to good or bad news. When bond prices increase, it may present an opportunity to enhance equity positions at more favourable prices while taking profits from bonds.

Dialling the risk up or down within an equity allocation is possible. Investing in emerging markets can provide high return potential but increased volatility. Size matters, too. Equity investments in small and mid-cap companies carry greater risk and price volatility than larger, more established companies.

We can also judge which type of bonds to buy within a bond allocation. For example, the prospects for bonds issued by different companies and governments may diverge at various points, or the attraction between shorter-dated and longer-dated bonds will sometimes differ. It is prudent to steer appetite between the two to manage risk.

Our active diversification

While the bond and equity relationship is often complementary, it is rarely static. Accessing different asset classes and actively adjusting the allocations as the investing environment shifts is crucial for effective portfolio management. The size of each ‘allocation’ we make in a portfolio is tailored according to the amount of risk it can take to meet its investment goals.

Our objective is not to wait for the perfect opportunity to invest by trying to ‘time the market’. Our preferred approach is to apply an asset allocation framework to portfolios where our investment managers regularly rebalance and refocus portfolios according to our client’s needs and prevailing market circumstances. This approach ensures that our portfolios are constantly fine-tuned to be in the best position to meet their long-term objectives.

Key takeaway

While volatile markets can be unsettling, it is important to remember the usually complementary partnership between bonds and equities. Together with careful management, they can build resilience into portfolios. Determining what mix of bonds and equities largely depends on individual goals, risk tolerances, and investment horizons while having the flexibility to take advantage of investment opportunities as they arise.

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