Building back bond exposure

The first half of 2022 was the worst period for fixed income since 1788, if we take the US treasury market as a proxy. Global bond markets have undergone a very significant repricing so far this year, with higher interest rates and wider credit spreads. But, nominal bond yields for the various fixed income asset classes are now at levels not seen in a decade. With the rise in yields, the opportunity to generate higher income over the coming years has increased substantially. As a result, bonds are becoming an attractive alternative to other asset classes. Their added benefit is that they have much lower volatility than equities. Bonds are again starting to behave as bonds typically do.

Bond returns were negative in the first half of 2022, alongside negative returns over this period from riskier asset classes like equities. But history shows that, at times such as these, we can expect bonds to start behaving as a hedge to equities again. At current yield levels, bonds are able to absorb further yield rises before total returns from the asset class become more negative again.

For example, a portfolio of high-quality short-maturity fixed income bonds currently delivers a yield of 3.9% with a duration of 3 years (source: Bloomberg Global Agg Corp 1-5 years). It would take a yield rise of approximately 130 bps before total returns start to become negative again. While for the longer-duration portfolios the sensitivity to rising yields is higher, the increased yield cushion has materially improved break-evens.

There are other reasons why we think bonds will behave as bonds again, and provide diversification against equity market volatility.

As much as bonds hate inflation, they love recessions. Historically, bonds have outperformed equities in a recession. Recession risks are more elevated today compared to a year ago, which should be more supportive for bond prices while potentially being negative for equity prices. Thus, bonds could go back to being a diversifier in an environment of weaker economic growth.

History shows that bonds have been a good diversifier to equities. For example, in years with negative equity returns such as 1992, the period 2000-2002, 2008 and 2018, bond prices rose (source: MSCI World and Bloomberg Global Aggregate Bond Index, USD hedged), providing diversification in a challenging environment for equities. Even so far in 2022 (the year to 31 July), while equities suffered a drawdown of 14%, bond returns declined by a more tempered 6.7%, showing that bonds have a role in limiting volatility even when they decline at the same time as equities.

Aside from the diversification benefits that bonds can provide, investors also recognize their income-generating ability and have historically allocated to this asset class to benefit accordingly. Typically, the yield is the most important determinant of longer-term bond returns, but in the low and even negative yield environment experienced in recent years, capital gains were the more important driver of fixed income returns.

The good news is that, with the rise in yields, bonds are back to providing income for investors and yields will again be a dominant driver of fixed income returns. Higher yields now mean higher income for bond investors in the future. While yields on government bonds are starting to look attractive, credit spreads have also widened substantially and now offer a more compelling compensation for credit risk. This compensation is warranted in light of heightened recession risk and tighter financial conditions. It is not yet clear whether inflation will come down meaningfully and fast.

With more uncertainty ahead, we believe that high-quality credit investments with a low risk of default offer good value for investors. In our view, bank and insurance debt looks cheap and cross-over credit (BB/BBB) offers appealing investment opportunities, too.