When investors talk of safe assets, they therefore generally mean bunds, treasuries, gilts, JGBs and other government bonds issued by large developed economies. In one sense, they actually are “safe” assets. They are typically negatively correlated with risk assets. More specifically, if the risk of recession is perceived to be rising, “safe” assets rally. That’s a good reason for a zero-term premium – why should you get paid to insure against recession?
Of course, for serious, long-term investors – Buffett, Soros and anyone else with a long memory, penetrating ideas and a proper time horizon – these are not really safe assets today. First of all, they are priced to deliver negative real returns, and the skew on the return distribution is all to the downside. The best an investor can hope for is to lose a little, unless they can sell to someone else at a higher price before the bond matures.
However, should this paradigm change, what looks like safe assets today could be highly vulnerable. Changing approaches at central banks such as the Bank of England could be a part of this paradigm shift; or perhaps all that is required is a change in investor sentiment. Our experience is that it doesn’t take a specific catalyst for investors to shift from being comfortable with low volatility to a fear of missing out. As the cost of holding cash and mainstream government bonds becomes ever more punitive, this shift in outlook arguably becomes more likely.
Interest rates, diversification, and correlation
Correlation patterns between assets are not static. The chart below shows rolling correlation between the FTSE 100 and UK Gilts. It shows that for much of the new millennium, holding a mixture of equity and government bonds has helped to reduce volatility.
Many of us have a subconscious belief that a negative bond/equity correlation is to be expected. Weaker growth harms equities, but helps bonds because interest rates fall. However, the 1990s show that such patterns are not to be relied upon if you are looking to add diversification to a portfolio. Looking ahead, if policy makers and markets decide that lowering interest rates is no longer effective in stimulating growth, or if we simply take the view that there must be some lower bound for interest rates, then it would be dangerous to place too much faith in recent history repeating itself.
Interest rates, asset valuation, and mean reversion
Today there appears to be an inconsistency of view between arguments that equities are expensive relative to their own history while bonds represent a “safety” asset despite in many cases being at all-time lows in yield. The reality is that such arguments are often driven by subconscious beliefs which in turn are the result of experience.
