Is it worth buying bonds

Equity markets around the world climbed to all-time highs in early 2021. In Germany, the Dax recently cracked the 14,000 point mark. The situation is different with bonds: Since the national economies are still in the midst of coping with the consequences of the Covid 19 pandemic, interest rates remain historically low - primarily due to the monetary policy of the central banks.

The current yield in Germany has been negative for around two years now. As a result, investors are faced with a dilemma: If you buy federal securities - that is, if you lend money to the German state in the expectation of getting it back safely - the return over the agreed term is negative. You get less money back than you loaned out. This now applies even if you choose the longest available term of 30 years. Germany is not an isolated case. A good quarter of the total global bond portfolio traded has negative returns.

Many investors are therefore faced with the question: Do government bonds still belong in my portfolio at all?

The corona crisis plunged the German economy into a severe recession. With the vaccines there is hope of a strong upswing. It will come. But the damage will keep us busy for a very long time.

Professional investors continue to buy government bonds

Banks, insurance companies and pension funds are still active in the market as buyers of government bonds because they are forced to do so, in particular for regulatory reasons. And of course there are also market participants who bet on interest rates falling even further in order to then realize price gains when reselling them.

In addition, it is above all the central banks that act as buyers. In Europe, the ECB has resumed and expanded quantitative easing programs. In addition to the bond purchase programs already in progress, the ECB has increased its Pandemic Emergency Purchase Program (PEPP) to 1.85 trillion euros and extended it until at least March 2022.

But what is true for the average saver and investor who invests long-term, for example because he has an eye on his retirement provision? Should he or she keep investing in bonds even if doing so reduces the total return on the savings plan or portfolio? The answer is: yes, because first-class bonds diversify and stabilize the portfolio. This also applies if there are costs associated with it, i.e. a diversification premium has to be paid.

Bonds and risk budgets

First of all, investors should be aware that the current interest rate situation is not an exception in the short or medium term. If you look at implied volatilities, i.e. price fluctuations in derivatives markets, today's valuations show that interest rates will be low for years to come. In addition, a study over a period of more than 700 years, published in 2019 by Harvard Professor Paul Schmelzing, shows that both real and nominal interest rates do not move around an average, with swings up and down. Rather, they are falling continuously and the development of the last few decades is no exception, but rather illustrates the trend of falling average interest rates.

It is therefore hardly risky if we assume that even if there were a turn away from the ultra-loose monetary policy, this will probably only lead to a moderate rise in interest rates.

In the investment year 2021, investors inevitably have to take risks in order to be able to achieve a positive return. The hope for constant help from the central banks will once again support.

In order to draw the right conclusions with regard to investment decisions, investors should be aware of the risk reduction motives associated with purchasing government bonds:

On the one hand, the risk dilution effect. This arises from the mix of high-risk assets with bonds, which have a very low risk (measured on the basis of volatility). The rule here is that bonds issued by countries with the highest creditworthiness have the lowest volatility and thus show the greatest risk dilution effect. They guarantee repayment when due, a point that is more important in times of crisis than the achievable return.

Second, the decorrelation effect. This describes an uncorrelated development of the return on bonds with other assets. At best, bond yields rise when stock returns fall and vice versa. Other asset classes also offer risk minimization, but only bonds show the combination of both effects.

Conclusion: pensions belong in every mixed portfolio

Even though situations like spring 2020 can arise, when stocks and bonds fell in parallel, bonds offer the most efficient form of diversification in most phases. Bonds, especially those with long maturities, should therefore be part of every multi-asset portfolio. They offer partial protection against losses. This is also not changing because government bond yields are negative. Minimizing risk by adding bonds in a portfolio has a price. The investment works like an insurance policy in which you pay a premium to reduce risks.

Does this then mean that investors will have to settle for lower returns on their portfolios in the future? No. But he or she should give risk management the necessary attention throughout the investment process. For this risk management, "risk-free" securities such as government bonds as an addition to stocks are still best suited. The aim should not be to take more risks, but rather to diversify an existing equity portfolio as best as possible in order to achieve a higher equity quota in terms of asset accumulation while maintaining a given risk budget.

What strategic options are available for this in practice? Instead of investing in capital-weighted stock indices, investors should invest in stocks with lower volatility in order to create a portfolio with minimal variance or rely on providers who pursue minimum variance strategies. Optimizing the volatility of individual stocks and their correlation with one another results in portfolios that, compared to capital-weighted alternatives, systematically show lower risks and, in the long term, higher returns for the same risk.

More on the subject: Profit instead of speculating! Our weekly investor letter BörsenWoche provides you with specific investment recommendations and updates on our model portfolios even during the corona crisis. Subscribe now!

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