Bonds: why we believe the time is now

Looking back to 2020, you would be forgiven for feeling that this relatively recent and relevant point in history has a somewhat dreamlike and distant feel to it. As the Covid-19 pandemic was ripping through the global population, politicians and other policymakers were implementing what were unheard-of policies in the modern era. In the background, central banks were busy flooding markets with cash and government fiscal policy ensured the taps were wide open, as much of the world stood still under lockdowns, and global production and trade dried up.

Bond yields continued their decade-long journey down to historic lows, meaning that the income cushions on offer to investors were sparsely padded and became rather uncomfortable to ‘sit’ on. Then, lo and behold, the inflation beast reared its ugly head in a way which the world had not seen for 40 years or more. The supply chain disruption; the decline, and in some cases reversal, of the three-decade long trend of globalisation; and the rather lavish spending by politicians armed with this mountain of cash had created a monster in the form of rapidly rising prices. The central banks were then quick to offer their services as protectors of their realms, riding out with aggressive interest rate hikes and quantitative tightening polices to tame this inflation beast. Markets were not immune to the effects, and bond yields soared upwards causing investors to yelp, as the low-income cushion starting point offered little protection against what were heavy capital losses.

Then and now

To flesh out precisely what this meant for bond portfolios, imagine yourself back in 2020, standing in the early stages of the global pandemic. Yields have fallen, as reality dawns that we are seeing a once-in-a-generation event and investors flock to the usual suspect safe-haven assets. So, what is the picture in bonds? Let’s look back across our three main areas of focus: the US, UK and European Union (represented by Germany).

The US 10-year government bond yield had fallen to around 0.7%. From this starting point, if yields only rose a mere 0.3% (30bps) to 1%, the loss for an investor would be almost 2%. Punch that up to bring the 10-year yield all the way up to 5% and you are facing an annualised loss of around 34%.

Alas, the story was the same across the pond, with both the UK and Germany facing significant paper losses for investors. Germany, in particular, had a negative yield starting point, which created significant losses across most scenarios. Indeed, the ‘best’ outcome would have been a near-zero return (+0.1%), with any other scenario generating large losses for investors.

Now we know with hindsight that these scenarios were very much what happened in markets, particularly throughout 2022, and investors faced a dark reality. Ultimately, the asymmetry of outcomes was heavily skewed against owning fixed income as an asset class. The lack of income protection meant that capital losses dominated returns, and the reality was that global investors dumped their bond holdings en masse.

Where does this leave us now?

Thankfully, this period of readjustment is now behind us. Fast forward to today, and we have already been through a significant repricing of yields higher. This means the income cushions have been restuffed and investors can once again sit atop these rather plump and attractive yields with a higher degree of comfort, knowing they have ample income padding as protection. Globally, inflation is cooling, and central bankers are beginning to dial back their restrictive policy measures and sheath their rate-hiking narratives, turning now towards defence against slowing economic growth and, ultimately, lower policy rates.

It is our view that we are close to the end of the economic cycle, and this will mean weaker growth, higher unemployment and thus more interest rate cuts will materialise. That said, even if we do not see a recession, it is still highly likely that we will see continued rate cuts to stabilise economies at target inflation levels. Ultimately, what this means is that if growth manages to cling on and not fall off the proverbial cliff, then bonds have the potential to generate large returns. And, if we slip into recession, then the potential rewards from fixed income should be even more bountiful.

Again, it is best to show this mathematically and visually. If we go from today’s starting yields it is notable that the picture is a stark contrast to before.

What conclusions can we draw from all this? Well, it is clearly evident that even if yields were to lift higher from this starting point, the income protection is doing its job to absorb losses. We believe we are no longer in a period where double-digit losses are a realistic scenario. Rather, potential 12-month returns from this point are, in our view, skewed heavily towards the benefits of owning fixed income.

What is more, it has become far less likely that we will see any further interest rate hikes, as inflation is moving in the right direction towards central bank targets of 2%.

If this assessment proves incorrect, we believe that, even in the worst-case scenario, the losses for bond investors should be rather minimal and manageable compared to those experienced post-pandemic.

We believe it is much more likely that bonds will perform very well, as we see more rate cuts, and the upside potential if economic data takes a turn for the worse could mean extremely generous returns. We like these odds and this positive skew. In our view, now is the time to increase holdings of core fixed income.

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This article is provided for general information purposes only and should not be construed as personal financial advice to invest in any fund or product. These are the investment manager’s views at the time of writing and should not be construed as investment advice. The opinions expressed are correct at time of writing and may be subject to change. Capital is at risk. The value and income from investments can go down as well as up and are not guaranteed. An investor may get back significantly less than they invest. Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds.