For an unconstrained multi-asset investor, the case for owning government bonds is now far weaker than it has been for decades, according to Aberdeen Asset Management.
“We used to hold very large allocations to government bonds in our multi-asset portfolios but we now hold zero allocation,” Craig Mackenzie, senior investment strategist at Aberdeen Asset Management, tells AM Watch.
These years, Aberdeen is very skeptical of that kind of portfolio structure which even normal people outside the financial world know well by now: Equities and bonds distributed in percentages with more or less emphasis on one or the other, depending on how much risk the customer is willing to take.
"I think a lot of investors, especially unsophisticated private investors, but also a surprising number of legacy funds, are still invested following the balanced bond-equity approach," says Craig McKenzie. Aberdeen began phasing out government bonds as early as a few years ago.
"At the end we held a few Australian bonds but got rid of those a while back, so that's really a quite dramatic difference from the previous times. And we don’t think we are going to be buying government bonds in the foreseeable future."
Low yields are caused by structural problems
However, are the low returns not simply a lingering effect from the financial crisis, simply waiting to fade away for government bonds to return to former prestige? Aberdeen is not of that belief. "The very low bond yields have to do with demographics and a global savings glut, and while that will correct over the very long term, 20 to 30 years, probably over the next decade it will not correct. What everybody has been looking to as the main source of diversification just doesn't deliver a meaningful return," Craig Mackenzie explains.
The Aberdeen multi-asset team doesn't have very high expectations to equities either for the next couple of years. Stretched valuations and low margin growth are the main constraints that will lead to a return around five percent a year over the next five years.
"We have replaced government bonds and investment grade bonds with a diverse group of alternative sources of return. Social and environmental infrastructure is a core part of our portfolio and asset backed securities is another asset class we really like as well as catastrophe bonds," Mackenzie explains.
Lower volatility with higher yields
Volatility will not necessarily increase, even if the security-building government bonds are left behind. The main reason for this is that many of the alternative asset classes have no correlation to equity markets or to each other.
"The attraction of catastrophe bonds based on reinsuring hurricane risk is that their returns have a low correlation with equities. A stock market crash is very unlikely to happen at the same time as a really bad Florida hurricane. So the combination of equities and catastrophe bonds actually gives a lower volatility than if you hold equities and, say, high yield bonds, because high yield bonds have a high equity correlation", Craig Mackenzie explains. "Low bonds yields are forcing us to look for diversification in unfamiliar places."
Seeing as many people have already made headway into alternative investments, there is a certain upwards pressure on prices.
"Some listed alternative assets are quite niche and so not available to the very largest pension funds. But small and medium-sized institutional investors (up to, say, a billion pounds) can still access the niche areas like listed infrastructure, and do so profitably. The largest investors must rely on private infrastructure opportunities. Some assets, like emerging markets local government bonds, are accessible to even the largest funds and continue to offer attractive yields," Mackenzie replies when asked about the scalability of the alternative asset classes. Aberdeen's flagship diversified growth and income funds have GBP 1.3 billion under management. They have plenty of room to grow before size becomes a problem – to around GBP 10 billion, perhaps.
"One attractive aspect of niche assets is that larger investors ignore them. Which means that the smaller pension funds, private investors, wealth managers who can still access this class, find it relatively inexpensive. This is a story that can continue to work for certain kinds of investors for a good while longer," Craig McKenzie concludes.
Aberdeen still has pure bond funds, and also invests in government bonds in multi-asset funds managed for clients against a bond-heavy benchmark.
English Edit: Marie Honoré