caution

Despite stocks’ rocky performance last week, I continue to prefer equities to bonds.

One reason: Many bond portfolios may carry more risks than in the past and more risks than many investors realize. It’s a topic that I, along with my co-authors, touch on in this BlackRock Investment Institute paper, “Forget Rotation: Think Risk Mitigation.” Here are four risks that we highlight in the paper.

1. The eventual end of quantitative easing. As economies recover, the torrent of monetary stimulus from central banks could eventually turn into a trickle.  When this happens, bond prices are likely to drop. Why? The private sector is bound to only swallow central banks’ freed-up supply for a price: positive real rates (and a resulting rise in yields).

2. Extreme positioning. In light of today’s low yield environment, investors are taking progressively more risks in their portfolios. Money is seeping out of cash and other safe harbors as investors search for income and some may have bought bond funds in the belief (or hope) they are money market funds with better yields. These “conviction-less” trades could easily reverse as many investors have their finger on the (sell) trigger.

3. Acute interest rate risk. At the same time, effective duration (bond price sensitivity to changes in interest rates) has been on the rise. This, combined with extreme positioning, can deliver uncomfortable returns and cause volatility in a so-called perceived “safe” asset class such as the 10-year US Treasury.

4. A breakdown in asset correlations. In recent years, markets and assets have moved in lockstep on the latest batch of economic data or central bank pronouncements. This, however, has changed in the past six months. Correlations between assets are currently just below the post-crisis average, meaning there may be more rewards now for taking risk than in the recent past.

That all said,  I don’t believe we’re at the start of an imminent “Great Rotation” of capital from bonds to stocks. As I’ve mentioned before, there are significant headwinds still facing the global stock market, including political uncertainty in Europe and the ongoing Washington fiscal drama. It likely will take a while for investors to feel comfortable fully embracing equities.

In addition, we’re not likely to see a large increase in yields anytime soon as factors keeping a lid on rates—such as central bank buying of US Treasuries, demand for Treasuries from institutional buyers and a lower supply of long-dated bonds—are still in place.

Still, ultimately, I expect equities to do relatively well this year given not only the hidden risks lurking in fixed income but also the global economy’s slow but positive economic growth, low inflation and reasonable valuations.

Though equities’ uphill climb will likely be slow and volatile, I believe this volatility is worth accepting in exchange for potentially higher returns.

Sources: The BlackRock Investment Institute, Bloomberg