Friday, 7 December 2012

Ben Gutteridge: Bond Trivia

For those who have yet to see the latest iteration of the James Bond franchise, Skyfall, you probably fall outside of the ‘enthusiast’ category. Sadly, this could leave you drastically under-prepared for the abundance of Christmas quizzes about to come your way. Here, therefore, are a few pieces of trivia to help keep you in the game:
  •  In 50 years of Bond movies, Skyfall is only the second film in which Bond suffers a gunshot wound
  • If you include the spoof Casino Royale, the unofficial Never Say Never Again and the TV movie Climax: Casino Royale, Skyfall is the 26th James Bond movie
  • Skyfall is the first Bond movie where Bond orders his Vodka Martini to be stirred
For those who have seen the movie you will know that the last fact is, of course, a lie. No matter who plays the lead, who directs, or who writes the script, there are certain rules by which all must abide. But, what if all ‘bonds’ were not quite so predictable?

In my previous blog I discussed the importance of negatively correlated assets in the construction of well balanced portfolios. As a reminder, these investments have a tendency to move in the opposite direction to stock markets and, as a result, are considered good hedges against deteriorating economic performance. An example of this is UK government bonds.
Source: Brewin Dolphin/DataStream

The above chart highlights the portfolio dampening effect UK government bonds can have on an equity portfolio. This is a consequence of bonds’ negative correlation with equities and is a quality that we have a high degree of confidence will remain. But, what happens if this relationship breaks down?

If we put ourselves in the shoes of a Spanish investor for a moment, in 2008 the equity component of our investment (the IBEX 35) will have delivered -37%. Helping to offset some of these losses, our government bond exposure will have returned + 10%. If, however, we look at the performance of these two assets classes this year, we get quite a different story. First, looking at the year to 25th July, which was the date Mario Draghi promised to do “whatever it takes” to save the euro, the IBEX had delivered -25.5%. Government bonds, which had previously behaved as a hedge to these investments, delivered a compounding -8.4%. Following on from this announcement, to the end of November, the IBEX has returned +38.1% and our ‘hedge’ returned +18.6%.

Clearly, the once negatively correlated behaviour between these assets has become positive – at least for the time being. This type of reversal creates lots of problems if there has been an over reliance on stochastic modelling to determine portfolio construction. More specifically, this would result in a sharp pick up in portfolio volatility.

In the UK, we have seen this in the earlier part of this millennium with the use of property. This asset, up until relatively recently, showed no correlation (and sometimes negative) with equity markets and formed a significant part of portfolios for those using purely quantitative techniques. Sadly, these bricks came tumbling down as a result of the financial crises.

Could the same happen with UK government bonds? We suspect not in the short-term, but we would not be so bold as to state this definitively. It is important that we use a number of vehicles to help cushion us from equity market reversals. Assets such as commodities, hedge/absolute return funds, currencies, high quality credit, and even volatility, can all play their role in balancing risks within portfolios. Bonds are a good bet, but should not solely be relied upon to save the day.

Ben Gutteridge

1 comment:

  1. But surely Spanish government bonds are really equities?