Friday, October 2nd, 2020

Dropping Bunds as the Benchmark

The time has come to say good-bye to an old friend and faithful servant. Our euro-denominated asset allocation models will no longer use 7-10 year German bunds as their ultimate safe asset. The decision is prompted by two considerations. The first is well-known: negative yields. The second is more abstruse: they no longer offer the best combination with other fixed income assets to create risk-efficient portfolios.

Instead of Bunds we propose using a pan-Eurozone index, weighted by the amount of bonds in issue – not GDP. There are several well-established benchmarks which can easily accessed. For the record, we are going to use the ICE BofA series and would be happy to include Greece even though it is not investment grade. In practice, it has little direct impact on overall performance, even though its indirect impact via Italy and Spain can be substantial. The 7-10 bucket for the Eurozone also has a negative yield, but this is a relatively recent development and it is only -0.13% as opposed to -0.62%

The big issue, as far as we are concerned, is the interaction with other fixed income assets. Over the last two years a systematic portfolio including bunds would have produced a total return of 17.0%, compared with 18% for a portfolio using the same process but substituting a spread of euro-sovereign bonds. These returns are more risk-efficient (1.44 vs 1.33) and have a smaller drawdown (-3.7% vs -4.4%). None of these are huge differences, but they all point in the right direction. We would take the idea seriously, even if we were only interested in incremental improvements, but there are other reasons as well.

Something happened in May. Politicians in Germany and the Netherlands may refuse to admit it to their voters, but the countries of the core effectively agreed to guarantee the credit of the countries of the periphery. The machinery for shared eurozone issuance may not exist yet, but debt-mutuality is the assumption on which the ECB’s polices are based. German bunds had a critical role to play in the portfolio when there was a realistic possibility that the Eurozone could break up. If investors no longer believe this is possible, we should move to a different benchmark. By way of corroboration, our model for eurozone bonds has failed to generate any significant alpha for the last two years and has almost exactly the same volatility and drawdown as the pan-euro benchmark.

Subject to all the usual caveats, we believe investors should move in this direction as soon as practical, ideally by the start of next year. We want to get this move out of the way, so that we can begin to think about the next stage of restructuring our fixed income portfolio, which is to lengthen the maturity of our government bond holdings. Our last report (How to Hedge an Equity Sell-Off, September 18) showed that 7-10 year eurozone bonds no longer provide any offsetting gains when European equity markets decline. Given that they too have a negative yield, it is time to move out along the curve.

In due course, we intend to adopt the 15+ years index as our new benchmark. Over the last two years it has produced higher and more risk-efficient returns than the 7-10 year benchmark. This change cannot be done quickly. It depends on the stock of available bonds and investors may want greater clarity about the legal arrangements. But purely from a portfolio construction perspective, this is a desirable and sensible direction of travel.

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