- 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 than the liability-hedging portfolio.
- 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.
Do bonds still diversify?
- Average relationship: The extent to which assets have distinct
drivers in scenarios close to the base case.
- Tail relationship: The behaviour of assets in downside scenarios,
i.e. crisis periods for the dominant portfolio drivers.
Is the cost of downside diversification justified?
- Time horizon: how long is the investment horizon
- Liquidity/cashflow requirements: is the investor looking to draw a regular income
- Dependency/reliance: is the investor reliant on this pot (e.g. for medical needs or education, etc)?
(1) Jenny will likely have a higher allocation to fixed income than
Olivia given the tail relationship.
(2) Jenny will likely have a much lower allocation to real assets than
Olivia due to higher liquidity needs.
(3) Within equities, Jenny will likely be more exposed than Olivia to
developed equities rather than emerging market equities as the
average relationship becomes more important for Olivia.