Mike Riddell on bonds: Bullish on the belly (of the curve)

Investors have always been told they should own diversified portfolios. Having a good mix of asset classes with positive expected returns that are uncorrelated – or ideally negatively correlated – to each other greatly improves the risk/return profile of the overall portfolio. A diversified portfolio has tended to include a decent slug of fixed income, particularly for the risk averse.

But decades of financial theory appeared to fail the Covid test, especially in the aftermath of the Russian invasion of Ukraine when sovereign bond yields rose from September 2020 to the end of 2021. Initially, these yield moves were bearable, because the global economy was recovering and risk assets were bouncing higher.

But the real pain came from the end of 2021 to October 2022, when 10-year US treasury yields soared from 1.5% to 4.2%, causing a total return on a treasury index of -15%, at a time when the MSCI World was down 25%. A year later and the 10-year US treasury yield had breached 5%.

Bond ballast

Countless articles at the time lauded the death of fixed income as the ballast within a balanced portfolio. But reports of its death were greatly exaggerated. Explaining the miserable performance of fixed income in 2021-23 is twofold.

First, inflation is the enemy of the bond investor. Fixed interest securities mostly do what they say: paying fixed interest over the life of a bond. Inflation makes these fixed-income streams worth much less in real terms, causing bond prices to fall accordingly. And the inflation surge of 2021-23 was second only to the 1970s for most countries in modern history.

The second reason is immediately post Covid, government bonds no longer offered ‘risk-free returns’, they were ‘return-free risk’. Policy rates were at the zero bound, or even in negative territory in some cases.

Trillions worth of sovereign bonds had negative nominal yields, let alone real yields.

But the outlook for high-quality government bonds looks a lot brighter now. Inflation fears have subsided and inflation rates around the world have dropped sharply back towards central bank targets. In many Asian economies, inflation is now below target. Covid supply shocks are behind us and excess demand stemming from extraordinary fiscal and monetary support has been withdrawn.

Valuations on government bonds are also much more attractive. In 2020, zero nominal yields and sharply negative real yields indicated negative expected returns, so financial theorists could have argued bonds were unlikely to be good diversifiers, since positive expected returns is a precondition. But now nominal, and especially real yields, are at their highest since the 1990s.

Thanks to dwindling inflation pressures and more generous nominal and real yields available, the global aggregate index (which comprises pretty much every investment-grade sovereign and corporate bond in the world) has again had a slight negative correlation with equities. The chart below plots the rolling 12-month correlation between the global aggregate (FX hedged) index and the MSCI World.

Not so fast

Does this mean investors should pile into sovereign bonds again? Unfortunately, it’s not so simple. If the returns on sovereign bonds were simply driven by growth and inflation expectations, then we would indeed be very bullish – we see little risk of inflation leaping higher again in the US, as tariffs should only cause a short-term increase in US inflation.

Outside the US, a hit to growth due to uncertainty is, if anything, likely to cause lower inflation. Little or no inflationary pressures, combined with slower growth, should mean substantially lower central bank policy rates and good returns for bond investors.

But the problem is bond returns for those with maturities much longer than 10 years are driven less by where central bank interest rates are going and more by technical factors such as supply (issuance) and shifts in structural demand from big liability hedgers like pension funds. So where you are positioned on the yield curve really matters.

This year has been a case in point – yields on two-year US treasuries, gilts and German bunds have fallen, but 30-year yields for all three countries are substantially higher.

We are bullish on most global bond markets in the front end and the belly of the curve as we expect lower inflation and weaker growth to encourage central banks to cut rates. But we see fiscal profligacy everywhere with sustained deficits. Add in a structural drop in demand for longer-dated bonds, and longer-dated bonds face real danger.

This article originally appeared in the June issue of Portfolio Adviser magazine