It is a sign of how much volatility has gripped fixed income markets in recent years that a month or so ago bonds sold off as investors feared US interest rates may not be cut, only for words from the US Federal Reserve to prompt a rally.
It is in such a climate that advisers and wealth managers, who typically view bonds as an asset class to dampen volatility, begin to suspect that bonds will enhance volatility in portfolios.
And alongside the cyclical and short-term factors that are impacting bond markets, structural curiosities also impacted returns in 2023, as despite markets fearing a recession was imminent, high-yield bonds – the fixed income asset class with the greatest economic sensitivity – actually performed well.
Matt Morgan, head of fixed income at Jupiter Asset Management, puts it bluntly: “Since 2021 bonds have failed investors."
He says this underperformance has driven demand for other asset classes, including gold, bitcoin and long-duration equities, which people own instead of long-duration bonds, and which would be expected to perform well when interest rates are low.
There are two ways in which a bond manager can add diversification to a portfolio, the first is via taking on additional credit risk, the second is by varying the duration of the portfolio.
Much of the turbulence in bond markets centres on the issue of duration. Longer duration bonds perform best when investors expect an economic downturn and rate cuts, while short-duration bonds do best at times when inflation expectations are rising.
Craig Inches, head of rates and cash at Royal London Asset Management, says that despite the volatility, it is presently “very difficult” for clients to want to take credit risk right now, because the yields on government bonds, even after the recent rally, are sufficiently attractive.
Phil Milburn, head of fixed income at Liontrust, says that at present he does not believe the spread – that is, the extra yield paid for taking extra credit risk – is sufficiently high to justify the extra risk relative to government bonds, as the latter have almost no credit risk.
Bryn Jones, head of fixed income at Rathbones, is of the view that the 6 per cent yield offered on some investment-grade corporate bonds is sufficient compensation, given that default rates on investment-grade bonds tend to be very low.
He describes this level of yield as “insurance” against negative economic outcomes, but says that if base rates are cut, he would expect the prices of both government bonds and investment-grade bonds to rise significantly.
Looking at duration
Jones says that as base rates fall, investors currently deployed into cash will move to bonds to capture the income above the prevailing cash rate offered.
He says the best way to diversify in terms of duration is to own long-dated government bonds for duration, and own bonds with a greater sensitivity to the credit cycle at the shorter duration level, as these may mature before an issue arises whereby they default.
Mickael Benhaim, head of fixed income strategy at Pictet Asset Management, says it has been a challenge for bond investors over the past year that long-duration government bonds and short-duration high-yield bonds have shown some correlation, despite appearing to be at the opposite end of the risk and duration spectrums.
