SOLUTIONS:ENHANCEDIs the bond broken?
Introduction
Kavit Tolia,
Investment Solutions
Senior Quantitative
AnalystLorenzo Garcia,
Head of Investment
Solutions, EMEA & APAC

Stuart Jarvis,
Investment Solutions
Quantitative Research
Director

An allocation to government bonds within a multi-asset
portfolio has traditionally played a vital role in terms of risk
management and diversification. However, the decadelong bull era in both government bonds and equities has
led investors to ask whether this assumption is still valid.
Additionally, near-zero yields across the globe bring into
question the cost associated with this diversification benefit.
Bonds1 are usually included within a strategic asset allocation (SAA) of a multi-asset
portfolio for two main reasons:n Income: They provide a stable source of income in terms of coupon payments,
along with a capital cushion in a rising yield environment. For investors with explicit
liabilities, this income stream gives bonds an important risk management role.
In this paper our focus is on the role of bonds in the return portfolio rather thanthe liability-hedging portfolio.
n Diversification: In times of crisis, government bonds benefit from the flight-to-quality
trade, partly driven by an expectation that central banks will stimulate growth by
cutting rates.
The diversification benefit has been brought into question recently and we will analyse
the validity of this hypothesis. Also in this paper, we analyse how government bonds
interact with other asset classes in a multi-asset portfolio and discuss the investor
characteristics which allow us to perform a cost-benefit analysis for including fixedincome allocations within our strategic asset allocation.

Do bonds still diversify?
Over the past decade we have seen both bond prices and risk asset prices rise intandem. This behaviour has brought into question the traditional view of government
bonds acting as a diversifier to risk assets and diluted the traditionally negative
correlation between these assets. However, the main question here is what we mean1

We will refer to government bonds as just “bonds” for the rest of the paper, unless mentioned otherwise.

2 / SOLUTIONS: ENHANCED

by diversification. When building portfolios for our clients we are consciousof two types of diversification:
1.	
Average relationship: The extent to which assets have distinct
drivers in scenarios close to the base case.
2.	
Tail relationship: The behaviour of assets in downside scenarios,
ie crisis periods for the dominant portfolio drivers.
For example, the portfolios we construct for clients have exposure to anarray of different asset classes which have long-term positive expected
returns, and which are not perfectly correlated. As such the long-term
portfolio performance will benefit from different sources of return over time
and will deliver an average return which is diverse, or from a broad set ofasset classes – hence the term “average relationship”.
These portfolios are also designed including asset classes whose role isto minimise drawdowns when markets enter risk-off periods, behaving as
diversified portfolios in downside periods – hence the term “tail relationship”.
Most joint asset class analyses focus on rolling correlations between
equities and bonds, but this is not an appropriate measure to understandthe tail relationships.
There is little benefit of achieving diversification only during “normal” market
conditions if safe asset classes such as bonds don’t protect the portfolio
when it matters. Measures such as rolling correlations amalgamate all
market conditions and so are not representative of investor preferences.
The best way to challenge this hypothesis is to analyse the behaviour ofequities and bonds in the tail.
For example, we have used US equity and government bond returns from
1871 onwards to analyse the behaviour of these assets during market
crashes and recessions, identifying 17 periods of crisis which range froma one-month crash in equities to a four-year recession. Clearly, there is anelement of subjectivity with respect to choosing these periods, but they give
us a decent idea of the interaction between equities and bonds during tailevents. We have only used US data here for two main reasons: the lengthand validity of the data is significantly better in the US compared to any
other economies; and global data would implicitly include multiple currency
returns, making it difficult to isolate asset class behaviour.

SOLUTIONS: ENHANCED

Figure 1. Relationship in the tail: equity and bond total returns

20%

14%

10%
2%

1%

0%
Total Returns

10.0

31%

2%

3%

3%

15%

14%
4%

2%

3%

9.0

15%
6%

6%

8%

7.0
-10% -11%-20% -15%
-23%

-26%

6.0

-11%

-15%

-40%

-20%

-26%

-24%

-35%
-44%

-21%
-30%

5.0
4.0

-37%

-60%

-50%

3.0
2.0

-80%

1.0

-81%

-100%
of
ic

18

82

ng

De

pr

18
73
e
-8
s
s
18 5 R ion
90 ec
e
-9
1 ssioRenc
Pa essnic iono
Pa f 1
19 nic 883
02o-0 f 18
3
Re 96
c
De
Pa essipres nic o on
sio
f1
n
9
o
07
G f1
Re rea 920
tce
ss Dep 21
ion re19 of ssio
73 19 nBl -75 37-3
ac
Re
8
k
c
Ea Mon ess
rly
da ion
20 y (00 19
s R 87
Gr ece )ea
ss
Au t Re ion
gu
ce
s
s
CO t 20 sion
VID 11
Cr
-1
a
9
Do sh
wn
tu
rn

0.0

Lo

Pa
n

8.0

Yield (%)

40%

US Equity Return (L)Change in US 10Y Yld (Decrease)

US Bond Return (L)Change in US 10Y Yld (Increase)

Source: Stock market data used in “Irrational Exuberance” by Robert J. Shiller and Columbia Threadneedle
Investments. Note: US equity returns are calculated by combining the S&P price and dividend data.
US bond returns are estimated by using the US 10-year yields and assuming a duration of eight years.
Past performance is not a guide to future returns.
Jenny
OliviaAs we can see in Figure 1, in every period of an equity market crashbonds provided a positive return, and this effect does not appear to havediminished over time. So, an allocation to government bonds does indeed
diversify away some of the risk within equities during tail events – andeven though it might seem that the negative correlation between equities
and bonds has been diluted when observing their average relationship,
the diversification benefit is still present in the tail. Additionally, this tailrelationship has stayed consistent across different regimes as demonstrated
by the 10-year yield at the beginning of each crisis period in Figure 1.

Cash and Government

CreditDeveloped Market Equities

Jenny
Journey-Driven
Less risky, more diversiﬁed portfolios

EM Equities

Alternatives

OliviaJourney scale

Outcome-Driven
More risky, less diversiﬁed portfolios/34 / SOLUTIONS: ENHANCED

Is the cost of downside diversification justified?
As demonstrated in the previous example, although government bonds
do provide downside diversification in a multi-asset portfolio, we must ask
ourselves if the cost associated with this is worth the benefit. This questionis even more appropriate given the low yields across the globe, leading tobonds being priced way above their historical average and therefore having
long-term expected returns which are close to the lowest in decades.
Unfortunately, there is not a simple answer to this question, and as withmost questions the true answer is “it depends”.
To illustrate this, let us think about the case of an umbrella on a typicalEnglish day. Assuming there is a certain probability of rain on a given day,different people will have a different outlook as to whether they need anumbrella. An individual who is very averse to getting wet (for example, if they
are on their way to a date) is more likely to buy an umbrella, regardless of theprice. In contrast, someone who is not too bothered about getting wet will
perform some sort of cost-benefit analysis on the purchase of the umbrella.
This is not to cast any doubt on the ability or effectiveness of the umbrella
to protect them from getting wet, but more related to the risk aversion of
the individual.
For an investor to determine their allocation to bonds, they need to think
about their preferences and objectives. These can be distilled down tothree main characteristics:
n Time horizon: how long is the investment horizon?
n Liquidity/cashflow requirements: is the investor looking to
draw a regular income?
n Dependency/reliance: is the investor reliant on this pot(eg, for medical needs or education, etc)?
A combination of these three characteristics helps to situate an investor
on a spectrum from “outcome-driven” to “journey-driven”, which gives
an indication of the appropriate bond allocation within their SAA. For aninvestor who requires a smooth performance journey over time, the portfolio
construction process should pay due attention to asset classes that can
provide downside protection via tail relationships. In contrast, for an investor
who is more relaxed about the path and is instead more focused on thelong-term outcome, we should aim to provide a well-diversified positive return
over time and attention should be given to the average relationship.

-100%Pani
Lo c of
ng
1
18
D 87
82 epr 3
es-8
18 5 R sion
90 ec
e
-9
1 ssioRenc
Pa essnic iono
Pa f 1
19 nic 883
02o-0 f 18
3
Re 96
c
De
Pa essipres nic o on
sio
f1
n
9
o
07
G f1
Re rea 920
tce
ss Dep 21
ion re19 of ssio
73 19 nBl -75 37-3
ac
Re
8
k
c
Ea Mon ess
rly
da ion
20 y (00 19
s R 87
Gr ece )ea
ss
Au t Re ion
gu
ce
s
s
CO t 20 sion
VID 11
Cr
-1
a
9
Do sh
wn
tu
rn

0.0

US Equity Return (L)Change in US 10Y Yld (Decrease)

US Bond Return (L)Change in US 10Y Yld (Increase)

Jenny

OliviaTo bring this idea to life, let us imagine two hypothetical investors who
have different characteristics, and discuss how these characteristics havean impact on their SAA (Figure 2).
Figure 2: Hypothetical investors and their characteristics
Characteristic

Jenny

OliviaTime horizon

MediumLong

Liquidity needs

High

Low

Reliance

High

Low

Primary objective

Risk-adjusted
returnReturnCash and Government

CreditComments

Given the shorter time horizon (andtherefore less likelihood of recuperating
any losses), high liquidity needs and highreliance, Jenny is more averse to volatility,and her objective can be best expressed
Developed Market Equities
EM Equities
Alternatives
as risk-adjusted
return rather thanpure
return.

Diversification motive

Drawdown
reduction

Maximisingchances ofmeeting returnobjective

Risk tolerance

MediumHigh

Even though both investors are risk-averseand so seek diversification, Jenny’s motive
is to protect on the downside. In contrast,
Olivia will be attracted by exposure to
return drivers to maximise the chances ofmeeting her return objective.

Jenny
Journey-Driven
Less risky, more diversiﬁed portfolios

OliviaJourney scale

Outcome-Driven
More risky, less diversiﬁed portfolios

Source: Columbia Threadneedle Investments, for illustrative purposes only.

We can see from Figure 2 how the two investors differ in terms of thethree main characteristics of time horizon, liquidity needs and reliance.
These characteristics can then be used to infer some additional features
about these investors, as highlighted in the same figure.
Based on these, we can make some educated judgements about theirinvestment strategy:(1)	Jenny will likely have a higher allocation to fixed income thanOlivia given the tail relationship.
(2)	Jenny will likely have a much lower allocation to real assets thanOlivia due to higher liquidity needs.
(3)	Within equities, Jenny will likely be more exposed than Olivia todeveloped equities rather than emerging market equities as theaverage relationship becomes more important for Olivia.

SOLUTIONS: ENHANCED

/5

20%

10%
2%

1%

2%

3%

3%

15%

14%
4%

2%

3%

9.0

15%
6%

6%

8%

8.0
7.0

-10% -11%-20% -15%
-23%

-26%

-40%

6.0

-11%

-15%

-20%

-26%

-24%

-35%
-44%

-21%
-30%

4.0

-37%

-60%

5.0

-50%

Yield (%)

0%
Total Returns

3.0
2.0

-80%

1.0

-81%

-100%

0.0

Pa
ni
Lo c of
ng
1
18
D 87
82 epr 3
es-8
18 5 R sion
90 ec
e
-9
1 ssioRence
Pas
nic siono
Pa f 1
19 nic 883
02o-0 f 18
3
Re 96
c
De
Pa essipres nic o on
sio
f1
n
90
o
7
G f1
Re rea 920-2
ce t D1sse
ion pre19 of ssio
73 19 nBl -75 37-3
ac
Re
8
k
c
Ea Mon ess
i
rly
o
d
20 ay ( n00 19
s R 87
Gr ece )ea
ss
Au t Re ion
gu
ce
s
s
CO t 20 sion
VID 11
Cr
-1
a
9
Do sh
wn
tu
rn

6 / SOLUTIONS: ENHANCED

14%

We can then make an informed decision about the broad asset allocation
for the two investors. For example, Jenny is likely to have an SAA which is in
the region of 60% in equities and a modest allocation in government bonds
to make the portfolio more resilient. In contrast, Olivia will be happy to have
Return (L)US Bond Return (L)an 80% allocationUSinEquity
equities
but a lower exposure
to government bonds toChange in US 10Y Yld (Decrease)
Change in US 10Y Yld (Increase)maximise the chances of achieving the return target. These allocations canbe thought of as the long-run asset allocation for each investor (Figure 3).
Figure 3: Long-run asset allocation for the two hypothetical investors
OliviaJennyCash and Government

CreditDeveloped Market Equities

EM Equities

Alternatives

Source: Columbia Threadneedle Investments, for illustrative purposes only.

As mentioned, these asset allocations are derived from our long-run capital
market assumptions, which we forecast using long-term risk factors driving
income and growth across asset classes. However, we also need to beaware of current asset valuations (eg, low yields) and how we expect themto evolve over thebusiness cycle, which we then translate
into asset class
Jenny
Oliviatilts around our long-run SAA.
Journey-Driven

Journey scale

Outcome-Driven

At
Threadneedle,
marketLessColumbia
risky, more diversiﬁed
portfolios along with the long-run capitalMore risky,less diversiﬁed portfolios
assumptions, we also forecast asset class returns which are more informedby asset valuations and where we are within a business cycle. Both setsof capital market assumptions are constructed in a way that ensuresconsistency across different time horizons.
We can then use these “valuation-aware” capital market assumptions totilt our long-run SAA to ensure we are aware of current valuations. This isparticularly important with respect to bonds given current yields across theglobe. For instance, while our long-run capital market assumptions assume
bonds are fairly valued, our valuation-aware view expects a degree of mean
reversion – which here means a rise – in yields and are therefore not as

SOLUTIONS: ENHANCED

bullish. Similarly, our valuation-aware capital market assumptions are morebullish on equities. All this will lead to the following tilts to the portfolios of
the two investors:
Asset class

Jenny

OliviaComments

Government bondsâââThe reduction for Olivia will be more
dramatic given the importance of theaverage relationship for her

CreditâßàWhile Jenny will reduce credit
proportionally with government bonds,
Olivia will likely maintain her credit
exposure, again focussing on the averagerelationship

Developed equities

áááWithin equities, Jenny will have a morepositive tilt towards developed equities,
focussing on risk-adjusted returns

EM equities

áááWithin equities, Olivia will have a morepositive tilt towards emerging market
equities, focussing on maximising thechances of achieving her return objective

Source: Columbia Threadneedle Investments, for illustrative purposes only.

Summary
There has been much discussion in recent years about the diversification
benefits of bonds and if the cost of this diversification is worth it for
multi-asset investors.
Having analysed two sides of this diversification – the tail relationship andaverage relationship – we can see that the tail relationship between equities
and bonds over the past 150 years shows that, even at historically low
yields, bonds have been an excellent tail diversifier in a multi-asset portfolio
during times of crisis. This confirms that government bonds still play a very
important role within multi-asset portfolios across many different regimes.
However, this does not take away from the fact that we need to perform
some level of cost benefit analysis when designing our investment strategy.
Any investment strategy needs to be informed by the investor’s
characteristics, which we have distilled into three main features: time
horizon, liquidity requirements and reliance. These can then be used
to infer the long-run asset allocation for the investor, ensuring the most
optimal portfolio given their preferences on average relationship versus
tail relationship. Additionally, this long-run asset allocation can be tilted toensure we are aware of current asset valuations, such as current record low
yields, while remaining consistent with the broad risk stance of the long-run
asset allocation. This process of designing a valuation-aware SAA ensuresthat at Columbia Threadneedle we aim to deliver the most optimal journey
for the end-investor without any dramatic asset allocation changes throughthe investment horizon.

/7

To find out more visit
columbiathreadneedle.com

Important Information: For use by Professional and/or Qualified Investors only (not to be used with or passed on to retail clients). This is an advertising document. This document is intended for informational purposes only and should
not be considered representative of any particular investment. This should not be considered an offer or solicitation to buy or sell any securities or other financial instruments, or to provide investment advice or services. Investing involves
risk including the risk of loss of principal. Your capital is at risk. Market risk may affect a single issuer, sector of the economy, industry or the market as a whole. The value of investments is not guaranteed, and therefore an investor may not
get back the amount invested. International investing involves certain risks and volatility due to potential political, economic or currency fluctuations and different financial and accounting standards. The securities included herein are forillustrative purposes only, subject to change and should not be construed as a recommendation to buy or sell. Securities discussed may or may not prove profitable. The views expressed are as of the date given, may change as market orother conditions change and may differ from views expressed by other Columbia Threadneedle Investments (Columbia Threadneedle) associates or affiliates. Actual investments or investment decisions made by Columbia Threadneedle and its
affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances.
Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee
future results, and no forecast should be considered a guarantee either. Information and opinions provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed.
This document and its contents have not been reviewed by any regulatory authority.
In Australia: Issued by Threadneedle Investments Singapore (Pte.) Limited [“TIS”], ARBN 600 027 414. TIS is exempt from the requirement to hold an Australian financial services licence under the Corporations Act and relies on Class Order
03/1102 in marketing and providing financial services to Australian wholesale clients as defined in Section 761G of the Corporations Act 2001. TIS is regulated in Singapore (Registration number: 201101559W) by the Monetary Authority ofSingapore under the Securities and Futures Act (Chapter 289), which differ from Australian laws.
In Singapore: Issued by Threadneedle Investments Singapore (Pte.) Limited, 3 Killiney Road, #07-07, Winsland House 1, Singapore 239519, which is regulated in Singapore by the Monetary Authority of Singapore under the Securities andFutures Act (Chapter 289). Registration number: 201101559W. This document has not been reviewed by the Monetary Authority of Singapore.
In Hong Kong: Issued by Threadneedle Portfolio Services Hong Kong Limited 天利投資管理香港有限公司. Unit 3004, Two Exchange Square, 8 Connaught Place, Hong Kong, which is licensed by the Securities and Futures Commission(“SFC”) to conduct Type 1 regulated activities (CE:AQA779). Registered in Hong Kong under the Companies Ordinance (Chapter 622), No. 1173058.
In the UK: Issued by Threadneedle Asset Management Limited, registered in England and Wales, No. 573204. Registered Office: Cannon Place, 78 Cannon Street, London EC4N 6AG. Authorised and regulated in the UK by the Financial Conduct
Authority.
In the EEA: Issued by Threadneedle Management Luxembourg S.A. Registered with the Registre de Commerce et des Sociétés (Luxembourg), Registered No. B 110242 44, rue de la Vallée, L-2661 Luxembourg, Grand Duchy of Luxembourg.
In the Middle East: This document is distributed by Columbia Threadneedle Investments (ME) Limited, which is regulated by the Dubai Financial Services Authority (DFSA). The information in this document is not intended as financial advice
and is only intended for persons with appropriate investment knowledge and who meet the regulatory criteria to be classified as a Professional Client or Market Counterparty and no other Person should act upon it.
In Switzerland: Threadneedle Asset Management Limited. Registered in England and Wales, Registered No. 573204, Cannon Place, 78 Cannon Street, London EC4N 6AG, United Kingdom. Authorised and regulated in the UK by the Financial Conduct
Authority. Issued by Threadneedle Portfolio Services AG, Registered address: Claridenstrasse 41, 8002 Zurich, Switzerland. Columbia Threadneedle Investments is the global brand name of the Columbia and Threadneedle group of companies.
columbiathreadneedle.com
Issued 06.21 | Valid to 12.21 | J31604 | 3609485