Associate, Investment Consulting: Dr Adrian Presse
For the first time in many years, interest rates have risen noticeably in 2022 and 2023, and as a result, conditions on bond markets have changed rapidly since then. What some are calling a regime change is, in fact, a return to normality. This means that fixed income (public & private) is becoming much more attractive again. But will the asset class be able to offer the stabilising characteristics that investors were accustomed to in the past? For the strategic asset allocation (SAA), there are many new aspects to consider that require a professional analysis and implementation.
Director, Head of Investment Consulting: Michael Kreibich, CFA, CAIA
Until the end of 2021, European bonds delivered above-average risk-adjusted returns for an extended period of time. This was due to artificially low volatility caused by the European Central Bank’s (ECB) expansionary monetary policy in the aftermath of the global financial crisis. After the impact of further interest rate cuts had become minimal in 2014, the central bank focused on its key bond-buying programmes, which helped stabilise inflation towards the ECB’s target of around 2%. However, efforts to gradually exit this policy were put on hold by the COVID-19 pandemic in early 2020, as inflation surged while at the same time the central bank was forced to launch a new emergency programme to stabilise capital markets by injecting billions more in liquidity.
As a result, the trend of falling rates intensified, resulting in notably low, and even negative, yield levels in the European bond market. The 10-year German government bond yield for example reached its ultimate historic low at -0.86% in early March 2020. The consequent limited potential for further significant declines in yields and associated gains in bond prices prompted many investors over the past years to gradually reduce their allocation to fixed income securities. Instead, investors shifted their allocation towards more opportunistic asset classes, which was especially beneficial for private markets. Depending on what regulation, if any, was in place, SAA shares in asset classes such as real estate, private debt, and private equity – and in some cases public equities – increased noticeably. Successively, the risks of the underlying portfolios rose significantly, especially when these were realistically modelled for the private markets segment.
About Berenberg
Berenberg was founded in 1590 and is today one of Europe’s leading private banks with its Wealth and Asset Management, Investment Bank and Corporate Banking divisions. The Hamburg-based bank is managed by personally liable partners and has a strong presence in the financial centres of Frankfurt, London and New York.
The year 2022 finally marked the turning point of falling yields, followed by a rapid rise in rates. The significantly increased inflation rates in the Eurozone – mostly driven by higher energy and food prices – forced the ECB to reverse its interest rate policy. However, despite historical precedents of interest rate increases of a similar magnitude and speed (1989/1990 and 1994), the resulting drawdown in the bond market was unmatched in its extent: the price of a 10-year German government bond, for instance, lost more than 12% over the course of the year. While there was a positive carry in the more distant past that could counteract interest rate increases, this component was negative at -0.18% by the end of 2021.
Simultaneously, the war between Russia and Ukraine began in Europe, which weighted heavily on market sentiment. Moreover, an economic slowdown became increasingly evident, causing riskier assets (especially equities) to also experience significant losses. The resulting absence of diversification effects created the perfect storm for multi-asset investors in 2022. Besides the US dollar and direct or indirect commodity exposure, hardly any liquid asset class did not record a substantial price decline during that year.
Investors who had allocated shares of their SAA to private markets investments certainly performed better. The valuation of private debt in the senior/super senior segment remained largely stable and even the real estate market as well as private equity investments did not show significant declines in value. However, it must be mentioned that transactions were also absent in these last two segments and therefore developments should be cautiously analysed with regards to the significantly increased cost for real estate loans and the possible impact of the multiple contraction of public equities.
Associate, Investment Consulting: Dr Adrian Presse
The good news is that fixed income securities are now priced at a fairer valuation and that the asset class offers a significant contribution to the overall portfolio performance again. This is, however, no regime change but rather a return to normality, which makes the asset class for investors far more attractive again for the upcoming years – at least at first glance.
The question remains whether the long-term correlation characteristics of bonds will return and if they will provide (again) stabilisation effects on overall portfolio risk, especially during periods of increased uncertainty. One answer to this will be revealed through the further development of inflation rates, as historically, in periods of high inflation, bonds have shown a stronger correlation with equities and vice versa.
In terms of the SAA, the effects of recent developments are diverse. Higher expected returns alone do not necessarily result in a higher portfolio allocation. The associated risks and changing correlations as well as the developments of the risk/return profiles of all other investable assets need to be considered. A professional analysis and implementation of the SAA is therefore highly complex and must be treated individually. It is essential to model different historical and forward-looking market scenarios to thoroughly understand the risk/return characteristics of the allocation and, as a result, make adjustments where necessary. Additionally, the benefits of a risk overlay need also to be analysed.
Due to the increasing level of complexity, experienced investment consultants are increasingly involved to determine the optimal portfolio allocation and interpret the results for the investor as part of a comprehensive consulting process. When applied professionally, the SAA can influence up to 90% of the investment success. Long-standing experience, the use of robust estimation parameters for risk, return and correlations, as well as a realistic and accurate modelling of illiquid asset classes such as real estate or private debt are crucial factors for the level of professionalism and, hence, the long-term success of the investment strategy.
By Michael Kreibich Head of Investment Consulting at Berenberg & Dr Adrian Presse Investment Consulting at Berenberg
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