Bonds: back for good?

Bonds often do well when inflation is under control, and if inflation has indeed rolled over, then it could be opportune timing to add duration back to portfolios. Here's why...

Jack Roberts, CFA - Fund Manager

1. Inflation has been halved

As the UK conservative government likes to mention, inflation has been halved, one of it's targets. There are doubts over how impactful it's policies have been in bringing this down, but nonetheless, for multi-asset investors it is good news. We saw this positive impact earlier in November, where we saw US inflation fall faster than market expectations, which led to a significant bounce in bond prices on the day.

When inflation is falling and with it interest rate expectations, bond prices are able to recover, with additional return earned by the higher yields that exist because of current rates.

2. Bonds now offer a margin of safety

On 4 August 2020, whilst the world was locked down, the 10 year UK Government Bond offered a yield of 0.08%. Investors, a loose term here, would earn 0.08% per annum to maturity, given markets were unchanged over the life of the bond. Markets did not stay unchanged for long, as supply side issues took form and pent-up demand fuelled a rise in inflation, not seen so strongly for decades.

Fast forward around 3 years to 17 August 2023, the 10 year UK government bond offered a yield of 4.746%. A 10 year rate move of 4.666%, almost devilish. The below chart looks at the approximate expected return for the 10 year bond in August 2020 and in August 2023 for given rate changes over a 1-year time horizon:

Past performance does not predict future returns. Source: Atlantic House modelling, 24-11-23. Modelling uses Gilt yield of 4.746% for August 2023 and 0.08% for August 2020. Assumes rate change at the end of the period.

The potential losses are now lower, whilst the potential gains are now larger. You’re also being paid to wait, earning over 4% if rates are unchanged.

The chart shows the now asymmetric return profile available from bond investments. This is why you should consider adding bonds and duration back to portfolios, and why bonds have previously been so painful to hold for “investors”. The opportunity cost of holding bonds is historically low.

3. Bonds can play the role of portfolio protector once again

Bonds tend to perform well during recessions, which are often deflationary. Think the global financial crisis (GFC) and more recently the Covid-19 pandemic. In such environments, bonds play a vital role in multi-asset portfolios, the role of portfolio protector, providing diversification to poor performance from equity allocations.

The table below shows data from the GFC and gives an idea of possible rates moves during a deflationary recession. The chart which follows plots the potential return of the 10 year UK Gilt for large rates moves over 2-years, where the downwards rate moves are similar to those seen during the GFC.

Past performance does not predict future returns. Source: Atlantic House modelling. Uses UK 10 year yield of 4.104%, as of 17th November. Assumes rate change at the end of the period.

Rarely have bonds ever looked so exciting, and duration as powerful a diversifier.

The asymmetric return profile is shown again by this chart. As another example of the potential diversifying power of bonds now, if the devilish 4.666% change in the 10 year rate was to repeat, but this time with rates falling instead, the expected return over 2 years would be slightly higher than 50%.

4. It is not all about extending duration

The yield curve is an exciting place to invest in, you can ride it, roll up it, roll down it, even find butterflies, but where should investors target? It is well known that the 10 year part of the curve moves differently to the 20 year point and the 30 year point differently to both. The below table shows the change in yield during the GFC for different maturity Gilts, using the same date for gilts as the previous table:

Past performance does not predict future returns. Source: Atlantic House modelling. Assumes rate change at the end of the period.

As shown, the 10 year rate was more responsive to the deflationary recession during the GFC. Outstandingly, the expected return from the 10 year bond was also higher, even though the risk (volatility) of holding the 30 year bond is far greater for investors. The findings reflect that targeting the 10 year point of the curve where possible, should benefit investors, especially those using bonds as a portfolio protector. Don’t just extend, target.

5. Bonds after the last hike

The Bank of England have the joyful job of trying to drive the car (our economy) in the rear-view mirror. Interest rates have a well-known lag effect, which makes this job even more difficult. This lag often causes the central bank to paint a too optimistic picture of the economy, and once poor data begins to trickle in, it is too late and quick, aggressive rate cuts are required. The last two rate decisions have been to pause at the Bank Rate of 5.25%. Interestingly, the median time to cut rates from their peak has historically been 339 days, close to 1-year. In that time, the median change in the 10 year rate has been -0.87%, with a median expected return over the time horizon of 9.89%. Don’t miss out on nearly 10% by driving in the rear-view mirror too.

6. Shocking times

Bonds tend not to perform well when inflation is threatening. Threatening inflation pushes central banks to raise short-term interest rates, often at the peril of economic growth and employment. Inflation appears to be rolling-over, favouring bond investments, but what if the market is wrong and the trend reverses?

As shown above, bonds have a margin of safety that has not been present for some time; staying still they can earn more than 4% a year and provide positive returns should longer-term rates increase 0.5%. Nonetheless, if inflation and rates move substantially higher, cash may be preferred.

However, cash will not provide much of an offset to equity drawdowns during a deflationary recession, longer-term bonds should, and that is why they have a place in a multi-asset portfolio, as a diversifier to equity.

Within fixed income, other than using cash which reduces diversification potential, are there other options for adding duration, even if inflation moves higher?

Yes, the Atlantic House Dynamic Duration Fund is a rules and signal-based system to duration management. Currently it favours bond investments, but if inflation starts to threaten again, the system should move away from bond investments and into inflation investments.

These derivative-based inflation investments tend to increase in value when inflation expectations or realised inflation increases, and this is often when bonds fall in value. Using these inflation investments provides genuine diversification within a fixed income proposition, and allow investors to begin to hold duration again, even if they may be worried about inflation moving higher once more.

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