Bonds: We are so back

There’s a thing I really appreciate about Man Group. Just saying “we have no house view” is easy to say but hard to do. To really live it, to see it in action every day as teams of extraordinarily smart people tackle the same problems is inspiring. And it’s weeks like these, where three teams all come to the same conclusion for their own unique reasons which make you sit up and take notice.

The conclusion is this – bonds are back.

Or at least, in more investment-focused terms, US government bonds are more of an attractive proposition now than they’ve been in a long time.

Let’s start with the part that’s been making the headlines, a 10-year yield above 4.3%, the highest since 2007. And not only that, a 3-month Treasury bill that has gone from 0 to 5.48% in a little over 18 months – an acceleration liable to incur significant g-force sickness…

In real terms, US government bonds now offer a yield that’s not too far off long-term US trend growth. Being able to lock that in today seems like a choice many more risk averse investors out there would make. And relative to equities, the opportunity cost of owning bonds versus stocks is at its lowest level for over two decades.

It’s here where I call on my colleague Henry Neville, CFA and his The Road Ahead letter. Simply put, bond yields are high, equity yields are low – that’s historically been good news for bond investors. In 150 years, we have never had a 10-year period where the relative valuation is this low and equities go on to outperform bonds.

“The long-term trend line would suggest that that over the next 10-years, the Sharpe ratio of the 10-year US Treasury will be more than 0.5 turns greater than that of the S&P 500 Index.”

Historic relationship between relative equity-bond valuations and forward risk-adjusted returns

Of course, we cannot talk about bonds without talking about inflation. It appears almost certain that the Fed will indeed pause in September on the back of moderating inflation, and at the same time resist a Bush-esque ‘Mission Accomplished’ victory lap. Perhaps this is not so much a pause as the Fed holding its breath? One minor tick upwards (see: August) may be counted as misfortune, two may be seen as carelessness.

Sidebar: one key thing I’ve been watching is the real and the perceived impact of rising energy prices on inflation. Both Brent Crude and WTI have hit their highest levels of 2023 – the latter breaking through $91 a barrel just today – on account of soaring demand and OPEC production cuts. This feeds through to transportation in terms of real higher costs, but it’s the increase in what people pay at the pump that has a psychological effect on how people see inflation’s direction and level. To make matters more difficult, this comes as the US has drawn down 41% (c.240m barrels) of its Strategic Petroleum Reserve since the start of 2022.

So what does this mean for institutional investors?

Practically, it means that diversification is back. I and many of my colleagues here at Man Group have written about the troubling rise in bond/equity correlations. Considering the 2020’s began at -0.6, this has almost completely flipped to 0.5 today. As Henry points out, if we were to revert to trend (+0.2), bonds will be a genuine, added value diversifier.

However, that’s not to say we should all blindly allocate to bonds en masse. In an excellent examination of bonds as a ‘comeback kid’, Tarek Abou Zeid and Edward Hoyle wrote last week in Bonds: Shaken, but not Stirred that while diversification and the safe haven nature of bonds can be effective, it’s on us as portfolio managers to do better than just ‘effective’.

Lastly, there’s an added wrinkle for hedge fund investors. Take my colleague Adam Singleton in his monthly commentary The Early View :

1. Systematic Macro investors have been very short government bonds following a torrid past three years;
2. Government bond volatility is elevated, meaning hedging this short exposure through out-of-the-money calls can feel expensive.

On the flipside, what if we’re wrong? There’s a pretty apparent bear case for bonds – an initial rate cut being mispriced by the market, resurgent inflation leading to higher for much longer, a labour market slowdown – but as our experience with the ‘super-forecasters’ shows, it’s the probability that matters and for now, on a short-term view, it appears better to be bullish on bonds.