Benstead on Bonds: why fixed income can become defensive again next year

Sam Benstead asks if bonds can once again become a successful portfolio diversifier after they fell in unison with stocks this year. 

Bonds are typically seen as portfolio insurance. The fixed income they pay bolsters returns for a mixed asset portfolio, and that income becomes more valuable when stock markets fall or central banks are forced to step in and support the economy with interest rate cuts.

But this year, they have been a liability, with bond markets falling even further than some stock markets. This is because the hidden risk to owning bonds is interest rate rises, which causes bond prices to fall as investors can get a better yield from newly issued bonds.

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This is shown most clearly in the performance of Vanguard’s LifeStrategy range this year. Its range goes from 20% in stocks and 80% in bonds, to everything in the stock market. The theory is that the more bonds you have, the lower risk the portfolio is, as it will be less volatile. The trade-off though is that more bonds means less growth over longer periods.

However, this has not happened this year – in fact, the reverse has. Vanguard LifeStrategy 20% Equity has fallen 14%, Vanguard LifeStrategy 40% Equity has fallen 11.5%, Vanguard LifeStrategy 60% Equity is down 9%, Vanguard LifeStrategy 80% Equity is down 6.5% and Vanguard LifeStrategy 100% Equity is off just 4%.

However, normal correlations between stocks and bonds may be re-established once central banks have finished raising interest rates. When they reach their “terminal” or peak rate, the assumption is that enough has been done to cool the economy and slow inflation. This means that central banks can once again use interest rates as a tool to stimulate the economy, which would boost bond prices, particularly those that can keep paying their coupons even when growth slows, such as developed market government bonds and safer “investment grade” corporate bonds.

The good news for bond investors is that terminal rates could be around the corner. A poll by Reuters of economists said that rates would peak in the UK at 4.25% in the first quarter of next year, and in the US that figure is around 5% by the spring.

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Ariel Bezalel, head of fixed income strategy at Jupiter Asset Management, says that the inverse correlation between stocks and bonds has broken down over the past year but will return once the central banks have finished raising rates.

He argues that this will happen because inflation will be controlled, and therefore central banks will have scope to act and spur economic growth.

Bezalel said: “The very powerful forces that brought inflation lower for the past 30 years are still intact, and some are getting stronger. One is demographics, with an ageing population now set to calm inflation rather than accelerate it.

“In the 1970s, a booming population led to more people working and demanding more goods, which led to price increases as the economy could not keep up with the surge in demand. Now demographics don’t point to high inflation. A contracting work force is disinflationary, as those in their 70s spend half as much as those in their 40s.”

His point is that inflation could look very different in a couple of years' time, with this spike following the pandemic merely a historical blip that could indeed prove transitory, albeit more sticky than many expected. Bezalel therefore believes that bond yields will fall – which is a result of investors buying bonds and bidding up their prices – once inflation is under control and falling.

The data says bonds will bounce back 

Vanguard also experts the diversification benefits of bonds to return following the simultaneous sell-off in stock and bond markets this year.

Its research team said: “As difficult as these times may seem, the case for multi-asset strategies remains strong. With their historical track record of resilient returns, we believe balanced portfolios [of stocks and bonds] can continue to achieve their intended outcomes for disciplined investors who stay the course.”

The firm stresses that the primary role of bonds in a well-balanced portfolio is to act as a ballast to equities over time, not as a driver of returns, and despite recent declines bonds are still in the best asset class to act as a counterweight to equities.

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This is due to the historically low correlation between the asset classes, with bonds often acting as a buffer during periods of equity volatility, it says.

Vanguard uses data to demonstrate this, saying that since the late 1980s, global bonds have consistently provided positive returns during the most severe global equity downturns, including the global financial crisis of 2007-08 and the Covid-19 pandemic.

It calculated that the typical 60/40 stocks-to-bonds fund, when equities and bonds have simultaneously declined over the last 100 years, recovered its initial losses after 10 months and provided an average annualised return of about 9% over the subsequent three years.

“Even when we look at the worst-performing 60/40 portfolios, where the average drawdown was nearly 30%, we found it took approximately 2.5 years to recoup their losses, after which the portfolios provided an average annualised return of just under 7% for the next three years,” Vanguard said.

Additionally, it argues that bonds have historically provided a buffer against recessionary sell-offs that often occur across riskier assets during periods of slowing economic growth.

“Thinking about the current market, investors who shift away from bonds now could end up locking in their losses while potentially damaging their ability to fully participate in the benefits of their bond holdings when market conditions eventually change,” it said.

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Looking ahead, the outlook for multi-asset portfolios continues to improve, not decline, driven by higher bond yields and lower share valuations, Vanguard says.

Its latest models show that the projected 10-year average annualised return for a 60/40 portfolio has increased considerably since the start of the year, from 3.3% to 6.8%.

Which bonds to buy

For investors who want to be more specific with their bond allocation, rather than just owning the market through a mixed-asset portfolio, Bezalel says the best portfolio hedges would be from investment grade bonds that are not in cyclical industries, so should not be too badly affected by an economic downturn.

He says that gilts also “looked reasonable” as he expects the inflation picture to improve in the UK and yields are much higher than they were a year ago.

“Gilts could join the bond party in 2023. Nominal yields are pretty handsome, and the added fiscal tightening now with rate hikes will squeeze inflation,” the Jupiter Strategic Bond fund manager said.

For adventurous investors, he argues that emerging market bonds, while “not for the faint-hearted” are beginning to look interesting. He says that inflation in Mexico and Brazil has peaked and central banks are already beginning to cut interest rates, which is good for their high-yielding bonds.

Sebastian Lyons, manager of the wealth preservation-focused Personal Assets (LSE:PNL) Trust, now has about 60% of the portfolio in bonds and under 30% in stocks.

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His preference is for inflation-linked bonds and gilts, and he bought gilts yielding more than 4% in the mini-budget sell-off, “a return not seen for well over a decade”, he says.

“A cost of capital and a risk-free rate (if only in nominal rather than real terms) is now available. This is a material and welcome change for savers and investors. It also provides an anchor to valuations, which has been missing for too long,” Lyons said.

Of course, bond prices can still fall, which would send yields higher and give investors a better entry point.

This would likely happen if inflation keeps rising. Indeed, Bank of America’s latest survey of professional investors showed that the biggest risk in markets, with 32% agreeing, is that inflation stays high. This is bigger worry than geopolitics.

Nevertheless, bonds are a much better buy today than a year ago, and if their defensive properties return then they will once again be a key way of reducing volatility in a portfolio – this could be essential if recessions rock stock markets.