What are the alternatives to bonds and are they riskier?
As bond yields sharply rose through 2022, the tendency for some has been to replace bonds with ‘alternative assets’ – total return funds, hedge funds, commodity indices, private equity or structured products to name just some that might fall into this category.
Although the inclusion of these alternatives may be an attempt to protect against market falls, you should be careful they are not just adding additional risk. A traditional industry measure of risk (standard deviation) may not highlight this because this can be distorted by the less frequent pricing of some alternatives. As many alternative investments are valued monthly, or even quarterly, these are likely to exhibit modest price movement (low standard deviation) for long periods giving the appearance of low-risk assets. However, in reality, the underlying assets can be as susceptible to market stress as those they’re replacing, just masked by an industry risk measure and, a sudden, sharp loss of value can similarly occur. Additional liquidity, default, currency and equity risks can be the outcome of such changes.
As we’ve seen, while bonds can fall in value, if issued by reputable governments and companies, they can still be presented as the relatively ‘risk-free’ asset. It can be easy to lose faith as values fall, however, we should remind ourselves that academically tested portfolio construction remains key to consistent long-term reward and risk control. Reacting to market falls and altering an investment strategy often leads only to increased costs and erosion of value, because movements in or out of markets usually come once value has been destroyed (selling out) or already made (buying in). Taking a seat in the corner, recovering and being able to continue the fight is usually the best strategy.