If you are buying a bond fund to diversify risk, make sure that’s what you are getting.
“It’s only when the tide goes out that you discover who has been swimming naked,” Warren Buffett said.
Read any A-level finance text, or better still the CFA exam, and you’ll note portfolio risk can be diversified balancing bonds and equities.
Classically much of the UK financial advice market uses a 60/40 portfolio as its default: 60 per cent higher risk equity or growth-related assets, offset by 40 per cent bonds and steady long-term value investments. Dispute the wisdom of that all you like.
Unconstrained is a dirty word
Less disputable, over the past decade much of that 40 per cent destined for lower risk bonds has found its way into stuff that behaves a lot like equity. If it walks like a duck, quacks like a duck, it tends to be a duck.
Perhaps the most dangerous word in finance is “unconstrained”. Putting cash into an unconstrained or lightly governed portfolio means the investor cedes control of the risk they are exposed to; many modern bond funds have huge investment flexibility as a result of the asset managers creating products that are designated as unconstrained.
Clients might find heavy weightings to junk bonds, deeply subordinate securities such as Additional Tier 1 bank debt or unhedged emerging market exposure. All of that might well be correlated to equities, rather than a source of diversification.
Remember they said Credit Suisse wouldn’t default. Since then, they’ve said it was a one off.
Often owning riskier instruments is not a problem. As long as markets go up, as long as economies are growing, funds with such positions should do better than those with less. They’ve just bought excess beta at the right time.
The challenge comes when things aren’t going well; when the tide goes out. In periods of stress, when safety and liquidity matter, the risky portfolio takes a hammering. This is exactly the time diversification becomes important.
April 2025 was the most recent stressed period. On so-called “liberation day”, equities plunged. Many down double digits in days. Was this a one-off aberration or a timely reminder we live in a risk prone world?
How did bonds fare? It depended completely on which bonds we talk about.
The US high-yield market compared to the pro-risk Nasdaq index. During April the two were incredibly correlated. To put it another way, junk bond investors suffered a similar tale of woe to those who owned Nvidia. But this is without the upside that comes from equity exposure in the good times.
But had clients owned German government bonds, you’d have been forgiven for thinking April’s wobble never happened. One part of the bond market acting to diversify risk, the other adding to it. Not all bonds are created equally.
Many will tell you subordinated debt, especially AT1 is a solution to all our problems: great returns and no risk.
Subordinated debt is a bond that pays out second in the queue in the event of a default, with the investors getting a higher yield than that offered by the same bond issued by the same company, but which is not subordinated — that is, the owner of the conventional bond gets repaid before the owner of the subordinated bond.
Just to be clear, AT1 risk is almost exactly the same as ordinary equity risk. Indeed, a recent Swiss court case reinforced that point saying AT1 holders had been unfairly treated because they had suffered more than ordinary equity investors, rather than equal treatment.
In the year to date, AT1 has done well as risk markets rallied. Yet investors who bought a balanced portfolio of government bonds and actual bank equity have done much better. The market-leading AT1 exchange traded fund is up around 8 per cent. Compare that with 40 per cent for Lloyds, 45 per cent Citi and a whopping 102 per cent for Deutsche Bank equity (as at 14/10/25), according to data from Bloomberg and Invesco.
By September 30, the US Treasury market had returned more than 5 per cent. A portfolio comprised of 50 per cent US Treasuries and the rest in Lloyds Bank shares would have made around 22.5 per cent. This is nearly three times the return on the AT1 market. If you want equity-like risk and equity returns, why not just buy the equity?
How did we get here?
Blame can be put on Mario Draghi. The ex-head of the European Central Bank famously said he’d do whatever it took to save the Eurozone. Part of the solution was quantitative easing, which saw the ECB embarking on a market manipulating bond buying spree.
That put a floor under many asset values, reducing the chance of losing money. It also took bonds yields negative — this was truly insane.
The combo of no income with a risk asset safety net forced many investors into alternative bonds — the junkiest of junk, most subordinate of subordinate, much like the run-up to the global financial crisis a decade earlier.
And fund managers, eager to sell, needing to beat the competition jumped on the band wagon.
Today’s legacy
We’ve had a proliferation of bond funds and investment strategies in recent years.
Money flowed in, often in response to pitiful retail bank savings rates. Demand for riskier bonds means many parts of the market now look more expensive than ever. Just at a time when economic and political risks start to elevate.
Many investors still believe they have a nice 60/40 portfolio. Many investors expect the 40 to protect as and when the next market downturn comes along.
Those that own a fund chock full of risky debt might find they don’t have the protection they expect.
Not all bonds are created equally. Some might even quack.
David Roberts is head of fixed income at Nedgroup