Investment
Comment
10th March 2023
Bonds
Following a sharp sell-off in bonds over the course of 2022, this note looks at the historical place of government bonds in portfolios and their potential in coming years.
Fixed income has historically provided two key characteristics in a multi-asset portfolio:
- A steady stream of income
- Diversification against riskier assets if the growth outlook deteriorates (acts like an insurance policy against equity losses).
In addition, since the early 1980s, bond yields have fallen steadily. This has meant that bonds have generated positive returns as well as providing portfolio diversification (or insurance) against equity market losses.
As bond yields fell, bonds generated strong returns but this reversed in 2021 as yields rose and bonds delivered significant losses.
Source: Artorius, Bloomberg
Good riddance to negatively yielding debt:
Negative Global government bond yields as a % of Bank of America/Merrill Lynch Global Government Bond Index
Source: Artorius, J.P. Morgan Asset Management
In 2020, the ability of bonds in the US and UK to offer either income or diversification fell as yields fell to record lows to below 1%. This had been the situation in Japan and Germany since 2015. With yields below 1%, investors had an unenviable choice: accept paltry returns by investing in government bonds at ever lower yields, or chase higher yields in lower quality parts of the fixed income universe and take on much more risk as a result. In addition, the diversification benefit of government bonds was eroded as bond yields reached a floor and didn’t fall further even as equity markets fell.
Low yields were a result of the ultra-loose monetary policies enacted during, and maintained since, the Great Financial Crisis in 2008-09 by Central Banks. These supportive measures of low interest rates and Quantitative Easing (QE) resulted in ever lower bond yields.
During Covid the Central Banks doubled down on the loose monetary policy to support governments and financial markets. Just three years ago, 90% of the global government bond market was offering a yield less than 1%, and 40% had a negative yield.
2022: Resetting rates
Coming into 2022, inflation started to build, and Central Banks began on the path of policy normalisation with higher interest rates. Inflation accelerated with the surge in energy prices caused by the Russian invasion of Ukraine and subsequent sanctions. In addition, labour markets in developed economies recovered more quickly than most had predicted, and wage pressures started to rise. Consequently, Central Banks raised interest rates and stepped away from QE. As a result, bond yields rose sharply, and bond investors experienced significant losses.
In 2022, the declines witnessed in fixed income markets were unprecedented. The UK government bond market fell 23% but bond market losses were a global phenomenon. The Global Aggregate Bond index fell by 16%, the worst annual decline since the index began in 1990 and more than three times as bad as the second worst year on record.
2023: Back to the past?
The sharp move higher in yields over the course of 2022 has seen the stockpile of negatively yielding debt all but disappear, and now less than 20% of this market yields less than 1%. Do bonds offer the ability to protect investors against economic and equity market turbulence? The answer is that it depends. If inflation continues to be stubborn and remain higher for longer, then the risk is that bond yields will remain at current levels and even move higher. This could be a repeat of 2022, when inflation and interest rate volatility caused bonds to lose value resulting in pressure on equities. If inflation falls back towards Central Bank targets, then bonds may once again become the ballast in portfolios.
If Central Banks drive economies into recessions to generate low inflation, then bonds may generate positive returns to offset the equity market losses likely in an economic downturn. The ability of bonds to diversify against recession risk – rising in price when equity prices are falling – is now also much stronger.
While it is not our base case, if the global economy did fall into a deep recession in 2023, investors would likely flip quickly from worrying about inflation to worrying about deflation. In this scenario, bond yields would have significant room to fall from current levels. If 10-year US Treasury yields fell by 2%, this would deliver a return of close to 20%. This is the kind of meaningful diversification against equity losses that multi-asset investors rely on when constructing balanced portfolios, which has not been available for several years given the very low level of yields.
Conclusion
2022 was a historically difficult year for bond investors but the opportunities available in fixed income are the most compelling in over a decade. Whether for income or diversification against recession risk, bonds deserve their place in a balanced portfolio once again, even though an element of selectivity will still be required.
Gerard Lane
Chief Investment Officer
All expressions of opinion reflect the judgment of Artorius at 10th March 2023 and are subject to change, without notice. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete; we do not accept any liability for any errors or omissions, nor for any actions taken based on its content. The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested. Past performance is not a reliable indicator of future results. Nothing in this document is intended to be, or should be construed as, regulated advice. Artorius provides this document in good faith and for information purposes only. Reliance should not be placed on the information contained within this document when taking individual investments or strategic decisions. Artorius Wealth Management Limited is authorised and regulated by the Financial Conduct Authority. Artorius is a trading name of Artorius Wealth Management Limited.