By Ben Seager-Scott, Head of Multi-Asset Funds at leading wealth manager Evelyn Partners
For several decades government bonds played a crucial role in most portfolios – institutional, professional and private – thanks to some key characteristics. They offered reliable, if rarely spectacular, returns in nominal terms at least. They offered stability, in that the bond markets did not tend to suffer the same short or medium-term gyrations as the equity markets.
And they offered diversification and ballast to investors because they often, but not always, moved in a different direction to equities.
In ‘the great bond bull market’, for four decades from 1980 government bond yields steadily reduced, through some notable bumps, to record lows in the late summer of 2020 – barely more than 0.5% in the case of 10-year US Treasuries, and negative in the case of German and Japanese bonds. This created decent total returns for investors, despite negligible yields towards the end of the period after global benchmark interest rates had been at rock-bottom for years.
Such stability was particularly welcome when equity markets turned downwards.
The end of the great bond bull market
By the end of 2020, yields had nowhere to go, and with the income-generating capabilities of bonds negligible, tentative obituaries for the 60/40 portfolio – 60% in equities for the good times, 40% in bonds for the bad, and for the yield – were already being penned. Then inflationary pressures clearly emerged in late 2021, and the Bank of England began hiking rates in December that year – well before Russia invaded Ukraine.
As inflation surged in 2022, fixed income failed to provide an income, to act as an effective diversification asset against equities, or to preserve capital. All of Bloomberg’s global bond indices are down at least 10% this year and some are down nearly 20%. Such losses have added to rather than mitigated equity market weakness. Even usually very stable long-duration bonds have taken a hit – as the managers of defined benefit pensions schemes know all too well – and that is unusual when recession is predicted for most leading economies.
Knowing about this did not necessarily help the average private investor, and particularly defined contribution pension savers who might have expected to rely on the safety of bonds as they neared retirement. While investors have searched hard for substitute assets, the unique attributes of government bonds, as experienced in the great bull market, are hard to replicate.
Signs of hope
With yields now at decade highs and the bad news on interest rates largely reflected in prices, fixed income may now be able to fulfil some of its roles in portfolios once again. Our asset allocation view on bonds has turned more favourable.
At the start of the year, we held the view that investors should generally avoid conventional government bonds – yields were near zero and they therefore offered little reward for considerable risk, given mounting inflation. The sell-off since then has been painful for investors in this asset class, many of whom were holding them as a source of diversification and ballast in their portfolios.
However, yields have risen a long way as financial markets have adjusted to higher interest rates, meaning we started to become more positive on bonds from around the middle of the year, and are now dipping our toes back into conventional government bonds. With yields on most mainstream bonds now above the forward-looking inflation measures, the outlook for 2023 looks hopeful.
We believe the role fixed income plays in a portfolio varies depending on where the holder’s investment strategy sits along the risk spectrum.
For higher-risk investors, it could be worth introducing more conventional government bonds, with around the same interest rate sensitivity as benchmark rates. These investors can collect an income while the bond holdings also providing some protection should there be further falls in equity markets.
For lower-risk investors, fixed income also needs to contribute to investment returns. Here, we would focus on shorter-duration government bonds and investment grade corporate bonds. The latter now have an attractive yield with less interest rate risk.
Outlook for inflation
Bond prices could of course fall further if inflation keeps on rising into 2023, but we believe that while it will remain high, inflation will come off its peak. There are still profound inflationary pressures: including higher wage demands, deglobalisation and the shift from efficient to more resilient supply chains. As supply chains move closer to home, developed markets are no longer importing disinflation from emerging markets.
However, just as the strength of inflation has surprised policymakers and investors in 2022, other scenarios are plausible. For example, interest rate hikes could choke off some of the demand in the economy just as supply chain problems start to resolve, creating deflationary pressures for a period of time.
Back to a kind of normal for financial markets?
After more than a decade of ultra-loose monetary policy and dormant price pressures, markets may be returning to a more ‘normal state’ with inflation and interest rates materially above zero. So, a different investing environment than we have been used to in recent years – but one not without opportunities.
The recent inflation shock drove an increasingly positive correlation between equities and bonds, which in the eyes of some commentators buried the 60/40 portfolio that had become an archetype for retail investors. That shock now appears to be moderating.
With concern shifting towards the strength (or otherwise) of economic growth, we would expect bonds to return to their more typical negative correlation. This is another argument for viewing bonds more favourably.
Shifting valuations, particularly in bond markets, have changed the risk/reward dynamics for investors. And this shift could demand nuanced alterations to investors’ asset allocation.