Will investors return to bonds?

The following article was originally posted on the?Mercer Yield Point Blog .?You can find this article along with more wealth news content?here .?

By Rob Kavanagh, Head of Portfolio Management, Mercer New Zealand

Government bond yields have risen significantly in the past two years. Is it time they reclaimed a bigger role in portfolios?

Over the past 40 years, developed market government bond yields have come down significantly. This has led to much lower bond allocations in investment portfolios.?

?This might be about to change.?

With the recent jump in inflation, central banks are raising interest rates in response. This will have a significant impact on the behaviour of government and corporate bonds.?

In the summer of 2020, the 10-year US Treasury bond yield fell to 0.55% as the Federal Reserve loosened monetary policy substantially to support the economy through the Covid-19 pandemic. As of the end of September, this yield had risen above 3.8%. It is a similar story in other regions such as the UK, where gilt yields have risen from below 0.2% to above 4% in the same period.?

What does this mean for portfolios?

Yields rise as prices fall, and vice-versa. On a basic level, this means that, for some investors, government bonds may be approaching an attractive entry point, especially if you are building a defensive portfolio.?

We are not piling back into the asset class yet as we still view government bonds as less attractive than other assets. In our view, there is still some room for yields to move higher and prices to fall, given continuing concerns about inflation and the prospect of more aggressive central bank action to combat it.?

According to our analysis of asset classes, we see developed market government bonds approaching an ‘equilibrium level’. This essentially means they are returning to long-term fair value after years of being expensive.

The role of bonds

Bonds play four key roles in portfolios. They provide diversification, stability, income, and a deflation hedge.

Diversification:?As inflation increased in the first half of this year and central banks turned hawkish (more likely to raise interest rates), fixed income assets performed poorly at the same time that riskier assets like equities also lost money. This undermined the diversification role that bonds have traditionally played in portfolios.?

However, we feel the worst may now be behind us. The return outlook over the next few years is a lot stronger than it was at the beginning of this year, and fixed income’s traditional role as a diversifier has been restored. With yields much higher than they have been over the past few years, there is an offsetting dynamic between interest income and capital gains/losses: even if bonds sell off leading to capital losses, investors are compensated by reinvesting coupons and maturing bonds at higher yields, and vice versa.

Stability:?The correlation with riskier assets is not common. Bonds tend to revert back to long-term averages, and these strong mean-reverting properties tend to decorrelate them from riskier assets. In other words, it is unlikely that the yield rise that we had in 2022 will be repeated in 2023.?

Higher yields will reduce demand and slow the economy, and bonds are more likely to fall into a stable range. This also means expected returns from bonds are higher, potentially reducing the need to own riskier equities to meet long-term investment goals. Fixed income volatility remains much lower than equities and so is more predictable. This stability may reduce portfolio volatility, and when coupled with their higher returns, we would expect greater allocation to bonds in the future.

?Income:?As yields rise, they tend to represent an opportunity to earn income. Historically, unless there is a default or extreme inflation, bond yields rise to a limit that slows growth. Owning bonds as yields rise means investors can take advantage of additional income, or ‘carry’. This provides a buffer against losses from default and from credit spreads widening further.?

Deflation hedge: Bonds are one of the best deflation hedges available. As inflation falls, yields also fall and bond prices rise. This may seem like a tail risk, but it was only a year ago that many market participants were worried about deflationary trends as the economy slowed.

Near-term expectations

It is worth watching how the market behaves in the coming months through this current inflationary environment. How central banks combat inflation, and their success in doing so, will play a key role in the path of government bond yields.?

The US Federal Reserve has been clear in its intended path for interest rates, but there is no guarantee it will be successful. The US economy will inevitably slow sharply as the Fed hikes rates. The central bank is explicitly targeting a period of much slower growth to soften labour demand and end the upward pressure on wages and thus inflation. Whether this leads to a recession and a so-called hard landing is uncertain.

High inflation and rising interest rates are typically not a good environment for risk assets such as shares. While markets have already fallen sharply so far this year, we are still seeing elevated risk levels and uncertainty over the near-term path of inflation.

Pay attention to when inflation is showing signs of peaking and the interest rate hiking cycle has come to an end.?

This is when defensive assets, such as developed market government bonds, could come into their own. We would expect assets like these to play an important role for investors in difficult periods.

Easing versus tightening

Another factor to consider is the gradual unwinding of quantitative easing (QE) programmes, which were initially brought in during the 2007-09 global financial crisis to stimulate economic activity. A further $12 trillion was pumped into the global financial system to support it during the Covid-19 pandemic.

Unwinding this will involve central banks reducing the amount of government bonds and other assets they now hold on their balance sheets, either by allowing them to mature or selling them back into the market.

The unwind of QE, also referred to as ‘quantitative tightening’, combined with interest rate hikes will likely push longer-term interest rates higher than they have been for some time. The International Monetary Fund has previously warned about the potential issues arising from a disorderly tightening, but there could also be attractive entry points for investors to corporate and government bonds as a result.

Whatever the future holds, the role of government bonds in investor portfolios is highly likely to change. Investors can look forward to bonds returning to their traditional role where coupons are no longer a rounding error and can deliver useful income. When this happens, investors should be ready to rethink their approach to this long-shunned asset class.

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