Despite stocks’ rocky performance last week, I continue to prefer equities to bonds.
One reason: Many bond portfolios may carry more risks than in the past and more risks than many investors realize. It’s a topic that I, along with my co-authors, touch on in this BlackRock Investment Institute paper, “Forget Rotation: Think Risk Mitigation.” Here are four risks that we highlight in the paper.
1. The eventual end of quantitative easing. As economies recover, the torrent of monetary stimulus from central banks could eventually turn into a trickle. When this happens, bond prices are likely to drop. Why? The private sector is bound to only swallow central banks’ freed-up supply for a price: positive real rates (and a resulting rise in yields).
2. Extreme positioning. In light of today’s low yield environment, investors are taking progressively more risks in their portfolios. Money is seeping out of cash and other safe harbors as investors search for income and some may have bought bond funds in the belief (or hope) they are money market funds with better yields. These “conviction-less” trades could easily reverse as many investors have their finger on the (sell) trigger.
3. Acute interest rate risk. At the same time, effective duration (bond price sensitivity to changes in interest rates) has been on the rise. This, combined with extreme positioning, can deliver uncomfortable returns and cause volatility in a so-called perceived “safe” asset class such as the 10-year US Treasury.
4. A breakdown in asset correlations. In recent years, markets and assets have moved in lockstep on the latest batch of economic data or central bank pronouncements. This, however, has changed in the past six months. Correlations between assets are currently just below the post-crisis average, meaning there may be more rewards now for taking risk than in the recent past.