Bonds aren’t what they used to be. Or are they?

Bonds have traditionally been a source of defensiveness, predictable income flow, portfolio diversification, and some capital appreciation for conventional well-balanced multi-asset portfolios. In the twenty years to 2020, bonds proved their worth in the wake of the dot-com bubble, during the market turmoil of global financial crisis, and in the low-rate environment that followed the latter.

Today, bonds are still a key component of multi-asset portfolio construction, but the way they perform their role is less predictable and the risks they bring have evolved.

In this article, Matt Brennan, Head of Asset Allocation, discusses what’s changed and what this means for the bond asset class.

The simplest way to look at this question is to break down bonds by their key characteristics:

The relationship between stocks and bonds has shifted so that adding bonds to a portfolio doesn’t reduce risk in every scenario. For example, the long-term assumption has been that when shares decline, government bonds usually provide some offsetting stability. But in the inflation travails of 2022, we saw equities and bonds fall together; as inflation soared, central banks had to hike rates aggressively, which hurt both asset classes. For bonds, the value of existing issues suffered, in part because of the erosion in value of the principal and fixed interest payments, and amid expectations of further inflation to come.

In the past, portfolio managers tended to consider the bond asset class as an all-encompassing, defensive, lower-risk asset within the traditional equity-bond 60:40 portfolio split. These days, it is necessary to distinguish just why certain bonds are held in a multi-asset portfolio. This is because bonds don’t all have the same defensive qualities, as we have seen by the variety of returns achieved by different bond assets in response to market turmoil in recent years.

Looking back before the global financial crisis, bond income was seen by investors as a key reason to invest in the asset class. Income became even more of a focus for investors in the ultra-low-rate environment in the wake of the crisis. Yields have jumped since the inflationary turmoil earlier in this decade, providing a renewed focus on their income-bearing characteristics. However, investors need to make sure they are appropriately compensated for the risks of each bond asset class, for example with credit spreads now relatively tight, the reward for taking on extra risk in, for example, high yield debt is more marginal.

Today, duration decisions are more active choices.”

In the past, longer-dated bonds tended to provide income and capital growth as interest rates declined. Today, duration decisions are more active choices, as it’s not fair to assume that long-term government bonds are a steadier option. Interest rate policy has been volatile in recent years, and portfolio managers have had to also consider the viability of fiscal plans and levels of government debt. As such, long-term bonds, which have the highest interest rate risk attached, have been increasingly volatile. Average bond duration is now longer than it was 20 years ago. This is partly because companies took the opportunity to issue longer-term bonds when borrowing costs were at very low levels, particularly during the 2010s. As a result, the corporate bond market is now more susceptible to changing rate expectations, which in turn has made management of duration more important. Medium-term bonds now often play a greater role in portfolios than in the past, due to their potential income benefits but without the level of interest rate risk of longer-term bonds.

The world is changing and bond volatility has been influenced by these shifts. Supply-chain issues, a lower-growth environment, deglobalisation, heightened geopolitical worries, energy transitions, demographic shifts, government debt levels, and myriad other factors have helped feed volatility and we believe will continue to do so. For example, fiscal policy is a growing consideration for bond investors, given elevated developed market government debt levels, and the resulting spending pressures.

Bonds still matter but achieving the right mix for long-term portfolios requires careful analysis.”

Portfolio construction is more nuanced than, say, 20 years ago. Bonds still matter but achieving the right mix for long-term portfolios requires careful analysis and consideration of what’s changed and which bonds fit which requirement best. Portfolio managers need to analyse, model and stress test fixed income assets for their potential reaction to different market pressures and environments, as well as their likely interactions with the rest of a multi-asset portfolio.

Despite the ongoing potential for short-term volatility, we are broadly constructive on the prospects for fixed income markets. In our view, real yields look supportive for government bonds, but we expect investment-grade corporate bonds to outperform government bonds over the long term and for high yield, supported by its lower interest rate sensitivity, to outpace investment-grade. Despite these nuances and opportunities to potentially add value with a long-term view, we believe a spread of bonds helps provide the best outcomes, diversified across a combination of geographies, risk ratings, durations, and yields.

Other assets can also be utilised in multi-asset portfolios to bring to bear to reinforce some of the same benefits provided by bonds. For example, private assets, depending on the mix of investments, could include income generation and defensiveness. It also brings further diversification, which is, as ever, crucial.