Who Packed your Parachute?
None of the Private Capital team have ever jumped out of a plane; Rick said when I asked him, “if the plane is going to land, I’ve always thought it was a bit silly”! If we were to jump, one thing we’d be very keen to know is that the parachute was in good working order and that it had been packed by a competent and experienced sky diver.
When you exit from the side door of a small plane at 10,000ft, gravity will ensure that you will only travel in one direction, and, in that situation, the parachute in your backpack has one very clear role – to slow things down and bring you back down to the ground with all limbs intact. Without it, fear would no doubt be an over-riding emotion whilst hurtling towards the ground at over 100mph, knowing that unless you’re very lucky, there is only one outcome.
For financial planning clients of Private Capital (who on average do not own 100% equity portfolios), the fixed income component of our portfolios acts in a similar way to a parachute. In times such as these where the market has been in relative free-fall, the quality bonds we hold slow the fall so that we reach the ground in one piece and are able to get back in the plane and do it all over again (hopefully to higher altitudes).
In recent times, shorter-dated, high-quality bonds that constitute strong defensive assets (well-made parachutes) have delivered low returns, and some people will have pointed fingers at anyone choosing to include them as part of a diversified portfolio. Bond yields have been at historical lows, with 5-year UK government gilts at or below 1% for the past three years. Today they stand at around 0.2%, meaning that they are yielding significant negative returns once inflation is considered. Low yields can be frustrating for some investors, but one needs to look at the bigger picture. As we mentioned above, in a long-term portfolio, bonds are included predominantly to provide some stability at times of equity market turmoil. They are not supposed to be exciting.
When faced with these low yields from high quality, shorter-dated bonds, investors have had two straight choices: accept the fact or go in search of yield by heading down the credit quality and/or buying bonds of longer maturity. We know that many have been tempted by the latter strategy, but we have stuck to our guns and defended our decisions, so that the portfolio is defended at times of downward volatility in equity markets such we are experiencing now.
The lower the credit quality and longer the term of bonds, the more they act like equities. We think of yield-driven bond strategies - particularly high yield bonds - as akin to picking up pennies in front of a steamroller, it works nicely until you trip over. The chart below looks at the performance of different types of bonds since the equity markets began to fall in February this year.
Figure 1: Bonds do not all perform the same at times of equity market turmoil
Source: Albion Strategic Consulting. Data: © Morningstar Direct. All rights reserved. Note: 1-5 = bonds with maturities between one and five years (i.e. short-dated)
It shows us that short-term, high-quality bonds have more or less held their value; doing the job we asked of them. The fixed income elements of Private Capital’s portfolios have returned -0.63% in 2020 (to March 31st) net of fund costs and an assumed 1% p.a. ongoing management fee. This has not only softened the downside return of equities in the portfolio as a whole, but also provided us with a reliable, defensive asset with which we can use rebalance the portfolios as we have described in previous notes.
Referring back to the chart, as we move to the right, down the credit spectrum to lower quality companies, returns become increasingly negative, -17.1% for Global High Yield. Owning these lower quality bonds with longer maturities, simply magnifies the falls, and, as it has always done, scared money runs from higher risks (in this case the possibility of defaults) which drives yields up and prices down even further. On the flip side, it tends to move into high-quality, liquid assets driving quality bond yields down and prices up…
As Warren Buffet once said:
‘Only when the tide goes out do you discover who's been swimming naked.’
Fortunately, whilst it may currently be a little chilly out of the water, we’re happy our portfolios have kept their trunks on.
If you’d like to know more about our approach to Investment Management, or to learn about how we help expats in Hong Kong with their Financial Planning, please get in touch at email@example.com.