Bonds justify their place in a multi-asset portfolio for two key reasons; diversification and yield. Last year they provided neither. Over the past 20-years investors have become accustomed to a world where bonds protect investors from losses when equity markets fall.
Last year, this assumption went flying out the window leaving many advisers in the uncomfortable position where their lowest risk clients suffered losses of similar magnitude to their higher risk clients. Chart.1 shows how across the broad market of multi-asset funds the lowest risk sector (IA 0%‒35%) suffered losses of around -10% over 12-months. This was in line with the highest risk sector (IA 40%‒85%).
Investors need a large yield cushion to defend against inflation
Investors in bonds receive a return from two key sources; yield and capital gains or losses. Over the last 10-years the yield has been a relatively small portion of bonds' returns against the behemoth of capital gains or losses.
Capital gains or losses are generated from changes in the price of the bond. A bond's price changes because the coupon payments are fixed, whereas the yield available in the market to investors varies. If market interest rates rise, investors will demand a higher yield and the bond's price must fall to make the coupon payments generate a higher yield on the price paid. Conversely if market interest rates fall, the bond's price will rise.
With hindsight, at the start of 2022 investors certainly weren't picking up enough pennies in front of the inflation steam roller. Investors who bought a broad mix of global government bonds were earning a meagre1% per year. Inflation came to the fore, peaking at over 10% globally, and market interest rates surged. The yield that investors were generating was quickly overwhelmed by capital losses, a perfect storm for bonds. Chart.2 demonstrates how the capital losses that ensued quickly overwhelmed the yield that investors had harvested.
As inflation abates it leaves opportunities in its wake
Inflation has risen sharply, which has given central banks no choice but to raise interest rates, consequently sizeable yields are now available to investors across bond markets. Inflation risk is by no means off the table but investors can now earn a substantial yield to start chipping away at last year's losses and to defend them against the risk of further interest rate rises. Government bond yields have increased by at least 2% for a 10-year bond since the end of 2021. A strong starting yield is the friend of fixed income investors as it provides a strong cushion against capital losses.
With inflation having shifted higher it's unlikely that we'll see a return to negative interest rates and quantitative easing in the near future. Does this mean that investors should throw the towel in and re-risk their portfolios into equities to recover the losses from bonds over the past year? We don't think so. Harvesting yield can help investors get their head back above water without bond yields falling back to the levels of 2021. Because of the yield being generated, bond yields don't need to fall all the way back down to the level of 1%, last seen in 2021, in order for investors to recover their 2022 losses. If we assume that bond yields fall by 1% this year, investors in global government bonds who invested from the start of 2021 should recoup their losses by early 2024 despite bond yields not falling back to the lows.
Inflation uncertainty will determine whether bonds can be the great diversifier
Diversification is the second reason to own bonds in a multi-asset portfolio. The capital gains or losses are what drive the diversification relative to equities. We tend to consider bonds to be diversifying to equities because in times of weakness in economic growth we typically see equities fall while bonds rise in value as interest rates fall. Chart.5 shows that in the slowdown phase (as determined by our economic cyclical model) of the economic cycle we tend to see bonds delivering positive returns when equities suffer losses, which is typically when we want to own bonds.
This diversifying relationship between equities and bonds does not always hold and we find that inflation uncertainty is a key factor in this relationship. Inflation uncertainty is the enemy of diversification for bonds. From the 1970s through to the 2000s inflation was typically high and variable. The average correlation between equities and bonds was positive meaning that bonds were not an effective diversifier for equities, as the prices of both tended to rise and fall in tandem. Since the 2000s inflation has typically been lower and less variable, so the market has been more focused on growth dynamics, where bonds typically act as an effective hedge. With this backdrop, the average correlation between equities and bonds was negative, meaning that over the last 20 years bonds have been an effective diversifier for equities. This all changed last year as global inflation hit over 10% last year and uncertainty around whether it will recede is higher. In this environment, positive correlations have returned and bonds have lost their lustre as a diversifier to equities.
The role of bonds has turned to the yield, the jury is still out as to whether bonds are the great diversifier.
- When inflationary risks loom, investors need a substantial yield cushion to protect them against capital losses on bonds as market interest rates rise.
- Higher inflation has caused market interest rates to rise and left attractive yield opportunities in its wake. This yield return will help investors to recover losses from last year without interest rates falling back to the levels of 2021. Similarly it will provide investors with a greater buffer against the risk of further rate rises.
- The fate of bonds as a diversifier lies in the hands of inflation. We have seen encouraging signs that inflation is easing but the pathway remains unclear. This uncertainty makes us nervous about holding bonds purely on diversification grounds, the role of bonds now turns towards the yield.
Multi-asset solutions for a changing world
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