The role of bonds in a multi-asset portfolio

Such has been the strong performance of bond prices that yields have, on occasion, gone to negative levels, and even those that are yielding a positive number are often trailing behind the prevailing inflation rate. 

It is a sign of where the bond market is, that while the wider world is preparing for much higher inflation, bond prices have actually just reverted to where they were prior to the pandemic, thus pricing in a world of low growth and low inflation.

In the aftermath of Rishi Sunak’s recent Budget speech, which warned of higher inflation and increased government spending, bond yields actually fell, as the market anticipated that borrowing would be lower in future. 

Central-bank bond buying has contributed to the higher price at which bonds are trading, as it means there is a constant buyer in the market. 

At the same time as this is happening in the bond market, equity investors are grappling with a rotation away from the equities that benefit from low inflation and into those that have the opposite characteristics. 

It is an anomaly that prompts Alec Cutler, who runs the Orbis Balanced fund, to say that he can “see no reason” to have bonds in a portfolio now, given the valuations and risk of inflation. 

Charles Hovenden, portfolio manager at Square Mile, says the extent of the over-valuation in bonds can be measured when comparing where yields were the last time the global economy suffered a sharp downturn.

This was after the global financial crisis, when yields were closer to 5 per cent than 1 per cent, which is the current UK gilt yield. 

With this in mind, he says that as a private investor he would have no bonds in his portfolio, but for client portfolios he feels they must remain, as a form of insurance. 

Anthony Rayner, a fund manager within the thematic multi-asset team at Premier Miton, says the way clients perceive bonds within a portfolio needs to change.

He says that whereas bonds were once viewed as a risk-free asset to hold in a portfolio (because they were backed by governments) this is no longer the case. 

Rayner says: “Bonds once offered investors both an inflation-beating income and played a defensive role in portfolios, but with yields so low, what role can they play in future? This goes to the core of the 60/40 question.

"Yes, how much protection can they provide against equity sell-offs with such yield compression but, equally, how they can materially detract from performance, as they have done year-to-date, for example, in terms of US Treasuries and especially UK gilts.

"The so-called risk-free asset has become a risky asset, with yield spikes driven by hawkish central-bank activity reverberating across asset classes. However, in terms of what role bonds can play in the future, it’s important to remember that not all bonds are the same.

"There is massive diversity across three dimensions: from short duration to long duration, good-quality credit to poor quality and, not to forget, liquid and less liquid.” 

Short-duration bonds are those that will mature relatively soon, and so carry less interest-rate risk, relative to those that have a longer date. 

Rayner says this is how one should allocate to bonds at the moment – by investing in shorter-dated bonds with higher yields, one can still attain an income and garner some element of protection from higher yields. 

One option for investors seeking a higher income from the bond slug of a multi-asset portfolio is to replace government bonds with riskier corporate bonds, including those with a high-yield credit rating.  

Bonds are given a credit rating based on the letters of the alphabet and numbers. Most developed-market, government bonds have a credit rating of AAA, while high-yield bonds are those with a credit rating of below BBB. 

Julian Howard, investment director for multi-asset solutions at GAM, says this is the wrong way to approach a bond allocation.

He says that while government-bond yields are so low as to not presently offer much protection against inflation, rather than taking on extra risk with the bond part of the portfolio, one should stick with the lower-risk bonds to act as a defensive asset class and use the equity and alternatives to combat inflation.

Charles Hovenden, portfolio manager at Square Mile, says one of the problems with allocating to riskier bonds in the current climate is that the extra income yield one gets for taking the extra risk (known as the spread) is currently very low, and not worth taking.

He adds that clients considering allocating to the highest-risk bonds should bear in mind that instruments that are called high yield in the UK are known as “junk” in the US. 

John Stopford, head of multi-asset income at Ninety One, is also reluctant to invest in bonds further down the market-cap scale.

He says: “‘Reaching for yield’ is not the answer if the question is, 'What defensive asset should I be buying instead of government bonds?'

"Moving down the credit-risk spectrum into high yield is fraught with greater risk, given the increased chance of capital losses and the lack of diversification to equities.

"We believe the use of equity-index futures and options to reduce risk provide a better alternative for diversifying against equity risk than government bonds currently.”