Strategic asset allocation
in an era of ultra-low interest rates

How low can we go?

The recent dramatic plunge in bond yields is the latest episode in a decades-long grind lower. The trend had already started to accelerate in the aftermath of the global financial crisis, forcing investors to adjust to a lower-for-longer environment. This is a particularly thorny challenge for institutions like insurers and pension funds that have liability-matching needs. The recent pivot of global central banks towards easier monetary policy has exacerbated the move, as shown in the chart below. The collapse of long-term interest rates raises important questions. To what extent do negative yields challenge government bonds’ role as the provider of resilience in portfolios? With the decline in rates dragging down expected returns across asset classes, where do investors go for returns in a low return world?

What a difference a year makes
Spreads between 10-year and 2-year bonds, 2010-2019

Sources: Refinitiv Datastream, BlackRock Investment Institute, Sept 2019
Notes: the chart shows the move in the spread, in basis points, between the 10-year and 2-year government bond for each respective sovereign over the past decade, and over the past year.

The shifting market dynamics underscore the importance of portfolio resilience – the backbone of our framework for strategic asset allocation that we have laid out over the past year. We believe our framework is positioned to tackle current market challenges because it incorporates uncertainty, blends different sources of returns and systematically sizes private market allocations. In our latest Portfolio perspectives, we show our process in action.

• Even lower for even longer interest rates. With global interest plunging towards zero or below, central banks are running out of monetary space to deal with the next downturn. An unprecedented response, likely involving getting money directly into the hands of public and private sector spenders will be needed, as we write in our August 2019 paper Dealing with the next downturn. The potential impact of such a policy – higher inflation expectations and bond yields - could be a world very different from the one today.
• The role of government bonds as portfolio ballast has come under scrutiny as the pool of sovereign bonds with negative yields burgeons. We believe there remains an important role for global government bonds in portfolios as ballast; this allocation is about resilience and less about return. Yet the cushion they provide against risk-off episodes gets thinner as yields approach their perceived floor – a phenomenon more acute with widespread negative yields in Europe, as highlighted by the relative underperformance of German bunds to U.S. Treasuries over the August 2019 equity selloff. At today's yield levels, the appeal of holding Eurozone government bonds as ballast has been reduced.
• Incorporating uncertainty in long-run return expectations is crucial in achieving portfolio resiliency. Our capital market assumptions (CMAs) and robust optimization technique are built with this in mind. The framework we follow helps prevent investors from placing too much weight on average return expectations in making strategic asset allocation decisions, and take into account downside scenarios.
• Investor-specific strategic asset allocations (SAAs). We show how four distinct investor types might deploy our toolkit to design their SAAs around individual needs and objectives - including time horizons - and to plan for downside scenarios. The results are materially different, yet the process we follow is consistent for each, underscoring its scalability. We discuss four examples: A global reserve manager investing globally in US dollars, a US public pension plan, a UK institutional multi-asset fund and an EMEA-based family office investing in US dollars. We plan to expand this list over time.

Bonds as ballast

Government bonds in a multi-asset portfolio are supposed to help cushion the overall portfolio impact of “risk-off” episodes. This has generally been the case since 1990, according to our study of U.S. and German government bonds, shown in the chart below. The hope is that bond prices rise when stocks fall. According to Bloomberg data, about 17 trillion dollars worth of sovereign bonds now have negative yields, putting their role as portfolio ballast under scrutiny.

Joining the dots
Monthly returns of government bond and stock returns during stock market selloffs, 1990-2019

Past performance is not a reliable indicator of current or future results.
Sources: BlackRock Investment Institute, with data from Refinitiv Datastream and Bloomberg, September 2019. Notes: The dots on the scatter plot represent stock returns and  corresponding bond returns in the U.S. over every stock market selloff since 1990. Selloffs are defined as rolling four-week periods during which the equity market falls by 5% or more. The shaded areas mark positive bond returns. The indexes used are S&P500 and the Thomson Reuters Benchmark 10-year Government Bond Indexes for the U.S. Returns are in US dollar terms. Indices are unmanaged. It is not possible to invest directly in an index.

Government bonds performed their role as diversifiers in recent risk-off scenarios, such as the summer of 2019 and at the end of 2018. As discussed earlier, one worry for investors is that policy rates in the eurozone may be nearing an ELB. What matters most from an asset allocation perspective is the implication of this lower bound for longer maturity bonds, particularly the impact on correlations between key assets such as government bonds and equities –a key driver of resilient portfolios, in our view. If market participants thought rates could not go lower, falling equity values would no longer coincide with falling yields, curtailing bonds’ diversification properties.

The strong performance of government bonds in the summer 2019 risk-off periods, marked in the charts below, should dispel any immediate concerns about their ability to defend against equity selloffs. We still see government bonds playing a crucial role in portfolios. Yet as shown in our unconstrained strategic tilts we have trimmed the size of our overweight relative to the start of the year, as our expected returns for fixed income are now materially lower. A further slide for yields from already ultra-low levels could well impact not just returns, but also the correlation government bonds with equities. The ability of government bonds to play the role of portfolio ballast is reduced as yields near the ELBs. This is underscored by the relative underperformance of German bunds relative to US treasuries through the August 2019 equity selloff. Holders of bunds should already consider diversifying holdings into other markets, such as US Treasuries and inflation-linked securities.

For European investors with liabilities, such as insurers, the structural advantage of euro area government bonds – such as the ability to hedge interest rates efficiently for liabilities and the comparatively favourable regulatory capital treatment - means the hurdle for a switch is greater. But it is still worthy of consideration, in our view. We see a more sizeable role for inflation-protected securities as we view higher inflation in the medium term as possible consequence of accelerating deglobalisation. In such a supply-side shock, the ability of nominal government bonds to provide ballast is likely to be further diminished, in our view.

Bringing our framework to life

We launch four, investor-specific SAAs that take into account our lower expected returns across asset classes, and each investor type’s typical objectives and constraints. These hypothetical SAAs are intended to show how our portfolio construction process applies to individual risk budgets, goals and limitations. Our resulting SAAs differ materially from one another, yet underpinning them is a consistent, scalable process, shown in the schematic below, that limits the need for subjective fixes.

Building blocks
BlackRock’s portfolio construction toolkit, 2019

Sources: BlackRock Investment Institute, September 2019. This schematic is for illustrative purposes only and subject to change without notice.

We study four broad client types: U.S. public pension plans, EMEA-based family offices investing globally in U.S. dollars, UK institutional multi-asset clients and reserve managers. We highlight the expected performance of each in the bottom 50^th percentile of our return pathways to emphasize our focus on downside-aware SAAs. We will update these SAAs every quarter alongside our asset class views and expected returns. We plan to expand the list of client segments over time.

Visit our Capital market assumptions interactive website.