A strategy focusing on reduced exposure to potential swings
- Our research confirms there is also a low-volatility anomaly in bond markets
- Investing in low-volatility bonds can make sense now
Lower-risk bonds can also generate positive alpha
Contrary to conventional wisdom, less volatile securities have tended to beat the broader market over the long term and escape the ill effects of boom and bust cycles, a phenomenon long recognised in equity markets. Research by our financial engineering team suggests such a ‘low-volatility anomaly’ can also create attractive opportunities for bond investors looking for more stable returns.
In an extensive study, the team found this low-risk anomaly could be found universally in global fixed-income markets irrespective of the currency or market segment, be it sovereign bonds, securitised and collateralised bonds, corporate bonds or emerging-market bonds.
What does this mean for investors?
From a risk-return point of view, investing in lower-risk fixed income can result in a higher Sharpe ratio. Including such bonds in a strategic asset-allocation portfolio should improve the risk-adjusted return.
This is even more relevant now since we would expect investing in fixed-income market capitalisation indices to generate much lower returns over the coming years now that fixed income is emerging from a long and strong bull market. After such a prolonged period of positive returns, investors may have grown complacent about the risks in fixed income when rates eventually rise.
Lower returns of high-beta fixed income can make investing in low-risk fixed income with positive alpha and low beta more appealing. Investing in low-risk corporate investment-grade and high-yield bonds could be of particular interest since it would bring additional returns from the credit exposure.
How best to capture the low-risk anomaly
In general, a defensive portfolio should outperform the market cap index substantially when that index does poorly. When the market does well, it should (at least) generate broadly similar levels of return.
Non-benchmarked investors will prefer absolute performance and can achieve this by investing in a well-diversified core portfolio of lower-risk bonds. They can seek additional performance by also investing in portfolios that exploit other anomalies such as value or momentum.
 Also see the white paper, “Low-Risk Anomalies in Global Fixed Income: Evidence from major broad markets”, in the next issue of the Journal of Fixed Income, vol. 23, no. 2 (2014)