For most of the decade after the financial crisis, advisers were presented with a dilemma.
Until that point the role of government and other lower risk bonds in client portfolios was to balance the volatility of equities, while also providing an income.
That was based on the notion that bond prices move inversely with equity prices, as when times are good investors have the confidence to buy equities and worry less about downside protection, so sell their bonds to buy equities.
This inverse correlation is the centrepiece of the 60/40 portfolio construction model, which underpinned many client’s ‘balanced’ portfolios.
However, following government intervention during the financial crisis, and in current times as interest rates and inflation have risen, bonds and equities have been falling in tandem, leaving investors in a quandary.
During the financial crisis, low rates contributed to most equity markets rising consistently, while quantitative easing involved central banks buying bonds in large quantities, pushing prices up and yields down.
This meant the traditional inverse correlation broke down. Now with rates rising and central banks reversing QE, bonds and equities are falling at the same time.
The extent of the pain being felt by investors can be seen in the 10 per cent decline in the value of the UK Gilt since the start of the year.
Matthew Yeats, head of alternatives and quantitative research at 7IM, says: “The income element of the reason to own bonds changed years ago, and while bond yields have risen, the income is still very low now. By some measure bonds are having their worst falls since the 1970s, but the income is still low because the yields started from such a low level.”
Bryn Jones, fixed income director at Rathbone Unit Trust Management, says that while bond prices have fallen sharply this year, “we are at the point where the yields on government bonds are now in positive territory, at least nominally, and that means [the old inverse correlation has returned and] you can once again get an income for taking out the insurance policy on your equity portfolio [because government bond prices will rise if equities fall], so while there has been a correction in the bond market, I don’t think its a case of bonds being dead”.
He adds that he began to buy bonds with a shorter date to maturity in October 2021, in expectation that rates would rise, which proved to be the right call, but also had exposure to more economically sensitive bonds, which have sold-off.
Jones says one of the key reasons why bond prices have fallen so sharply this year is that usually when interest rates are rising, the economic outlook is positive, so the economically sensitive sectors do well, but with rates rising and the economic outlook darkening, all parts of the fixed income market have suffered.
Bond yields move inversely to bond prices
Richard Carter, head of fixed income research at Quilter, says: “The principal role in a balanced portfolio is to provide diversification. In a balanced portfolio we would typically have 15-20 per cent in bonds, and the balanced portfolio would be the majority of our clients.
“For the more cautious client, we would perhaps have 40 per cent in bonds. To be honest, right now there is a case for having cash rather than bonds – we have high levels of cash in some portfolios.”
Despite slowing economic growth rates, investors are shunning bonds, according to Rupert Thompson, chief investment officer at Kingswood. The big risk that everyone is worried about in markets right now is inflation, he says, and high inflation is very bad for bonds, so they cannot play their traditional role as protector against equity market risk.
This is because the spending power from the fixed income of a bond is diminished by the rising prices that are the result of inflation.
Jeff Keen, head of fixed income at Waverton, says he has been “very negative” on bonds for a very long time, due to higher inflation and concerns around valuation.
Thompson says the market has been “taken by surprise” at how quickly interest rates are rising, “and now we need some clarity on when policy will stabilise”.
While many market participants are concerned about recession, Thompson says: “While economic growth is slowing, it is slowing from a high starting point. There will come a time when people view the main threat to portfolios as being from recession, rather than inflation, but we are not at that point yet.”
Keen adds: “The market is forward looking, so owning long-dated government bonds now is prudent, as, in time, the focus will switch to worries about slowing growth, and that will lead to government bonds performing strongly.”
Carter’s view is that “if we start to see recession coming down the line, then bonds become worth a conversation. The area that is of most interest right now is high yield. Because the economy is growing, companies should be able to pay their debts while the higher income from those bonds offers more protection from inflation.”
Tim Foster, who jointly runs the £800m Strategic Bond fund at Fidelity, admits that inflation is “toxic” for bond investors, but says the recent sell-off in government bonds actually means they can revert to their pre-global financial crisis status as diversifiers if a recession happens. While equities and bonds have both fallen this year, government bonds have fallen much farther, and would be expected to rise in the event of an economic downturn, while equities would fall further.
He says the reason interest rates have risen so rapidly and are expected to continue to do so is that “there is only a narrow window” due to the speed at which economies have recovered after the pandemic, while also being keen to regularise monetary policy in advance of any economic slowdown in the future.
Yeats’ view is that with unemployment generally very low around the developed world, “economies can tolerate rates going a little higher from here”, and says that he thinks bonds may be starting to price-in correctly the longer-term inflation outlook.
He says: “The days of inflation being very low are probably over, I think it will settle down at between 2-3 per cent, and I think bonds are already pricing in that sort of outcome.”
In that scenario, bonds would presently be fairly priced for the long term. Yeats says he does not believe a recession is imminent due to the presently very low unemployment rate.
An investor determined to escape the uncertainty of rising interest rates and commodity-induced inflation could look to emerging market bonds, as rates have already risen in many of those economies, so the next moves could be downwards, while higher commodity prices boost economic growth.
But Carter tends to avoid this part of the market, saying there are often idiosyncratic risks that are difficult to account for, so he prefers more generic high-yield bonds.
Keen’s reluctance to invest in emerging market bonds centres on his view that such assets tend to perform poorly when the US dollar is strong, as it presently is.
Thomas Wells, who runs an inflation-linked bond fund at Sanlam, says that while the securities in which he invests have become more expensive, they presently offer a protection against inflation, in that the yields they pay match inflation.
Thompson says that while the consensus opinion is that quantitative tightening should lead to bond prices falling because central banks will be selling vast quantities, it is also possible that the market response to quantitative tightening could be to anticipate the resulting economic slowdown and so buy more bonds. Though he says the latter is not his view at present, he thinks it is a possibility.
Foster says he “doesn’t know” why quantitative tightening is happening now, as there is no urgency to do it, whereas there is a need to raise rates.
His fear is that QT alongside rate rises could precipitate a recession, alongside a sell off in the bond market.