Balancing risk exposure in bond portfolios

Diversification in the age of rising stock/bond correlations

In a well-diversified portfolio, as one asset class declines, another should rise, mitigating risk and minimizing losses. Yet that is proving to be easier said than done. As fixed-income and equity markets seem to have shifted to risk-off, investors are struggling to find assets that move in the opposite direction from other assets, leaving portfolios exposed to synchronized losses even if they are diversified. Specifically, the recent performance of stocks and bonds has been moving in the same direction: down.

So how to achieve better diversification in times like these? In our view, bonds are still a reliable diversifier in a market rotation, especially as we get late in the business cycle. Better balancing risk exposure in a bond portfolio is critical to realizing the benefits of diversification.

As it stands, investors basically have two choices. They might find short rates extremely attractive, primarily for income generation, but that approach will be limited in its ability to provide a counterbalance in the event of a tail-risk event. The alternative is to assume longer-duration exposure with a tilt towards interest rate risk, which would provide diversification against a growth slowdown as well as an insurance policy against a tail-risk event.

For those reasons, we are constructive on the bond market. We see it priced appropriately, with a bias toward downside risks as higher rates bite into debt-laden consumers’ ability to spend. We continue to believe the Bank of Canada and the U.S. Federal Reserve are likely to take a pause in the tightening cycle early in 2019, as growth cools and inflation expectations remain well anchored. Going forward, we expect a flatter yield curve, monetary tightening and a corresponding liquidity drain, and positive front-end rates to persist into the late cycle, creating more volatility in risk assets.

If that turns out to be the case, then benchmark duration in fixed income can help to diversify a portfolio

Aubrey Basdeo, Managing Director, Head of Canadian Fixed Income, BlackRock, is a member of the Product Strategy Team within BlackRock's Model-Based Fixed Income Portfolio Management Group. He leads the product strategy effort in Canada for both the Institutional and iShares businesses.

Notes and Disclaimer

© 2018 by Fund Library. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. This article first appeared in the BlackRock Blog on the BlackRock Canada website.

Important information

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

© 2018 BlackRock Asset Management Canada Limited. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. Used with permission.

ICR1118C-650356-2017147