Interest rates globally are being reduced to near zero to make money cheaper and encourage people and businesses to borrow and spend and invest.
By Ghazal Jain
Covid-19 has changed life as we have known it. However, have you stopped to think about what change the health crisis is bringing to the world of investments? Well, it is going to have a lasting impact on the traditional 60-40 asset allocation that most investors subscribe to.
In the pre-pandemic world, bonds may have zigged when equities zagged. But this might not be true in the future, making it imperative to revisit a longstanding investment tenet: the use of bonds as a diversification tool against equities.
Problem of high risks & low rates
The economic havoc wreaked by the coronavirus pandemic has plunged the global economy into a recession. Interest rates globally are being reduced to near zero to make money cheaper and encourage people and businesses to borrow and spend and invest. With widespread unemployment, wealth destruction and risk of more waves of infection, hopes of a quick economic rebound are now getting replaced by expectations of a W-shaped recovery and speculation that more policy action may be needed
In spite of this, equity markets have been soaring. Sensex P/E in July is back to February levels of 24, when Covid-19 had not yet reared its ugly head. The disconnect between the financial markets and the real economy is most likely based on the liquidity tsunami and expectations of continued support by central banks. This mispricing of risk and resulting rally in the equity markets could derail as and when ground realities emerge or risk-off sentiment returns, increasing the chances of a pullback in equity prices.
As of now, we have sub-zero rates in parts of Europe and Japan. US Treasury bonds now sport rock-bottom interest rates with the US 10-year note yielding a paltry 0.63%.Closer home, the RBI repo rate now stands at 4%, the lowest it has ever been. The India 10-year bond yield is currently yielding 5.83%, the lowest it has yielded in more than a decade.
Short-term and high-quality bonds now have low rates and limited upside. Investors can opt for higher yields through longer term or lower-quality bonds, but will end up taking on duration or credit risk. Even there, the potential for bond price appreciation isn’t much considering that rates are at all-time lows already.
So effectively, bond investors are staring at low annual payouts as well as limited price appreciation going forward. This is making investors question bond markets’ ability to act as a hedge against equity price volatility as it has traditionally.
Gold to the rescue
Interestingly, the same macroeconomic factors of heightened risk, low interest rates and high inflation are increasing the portfolio relevance of another asset class—gold. Heightened risk makes investors seek stability of risk-off assets like gold which have zero to negative correlation with risk assets like equities. This feature of gold makes it lower portfolio risk and aid in stability of portfolio returns. Additionally, lower interest rates make non-yielding gold more attractive to hold.
Thus in the current scenario, gold, with YTD returns of 25%, can be more useful than bonds in alleviating equity risk, diversifying the portfolio and helping investors achieve long-term investment objectives by beating inflation, warranting a higher portfolio allocation to gold than held historically.
Bonds usually make up a major chunk of investment portfolios, and while it’s not practical for investors to fully replace all bond exposure with gold, the environment warrants augmenting gold exposure.
The writer is associate fund manager, Quantum AMC