Are bonds still useful in a multi-asset portfolio?

But in the decade since the end of the financial crisis, central bank policies and factors such as ageing populations have caused yields to tumble, and set new record lows over the past decade. 

The raison d'être of multi-asset funds is to achieve diversification of returns, but if bonds and equities are correlated in terms of returns, why use bonds at all?

The answer, says Will McIntosh-Whyte, multi-asset investor at Rathbones, is that while the correlations might have changed in the short term, “over the long term bonds still play the same role in portfolios.

"We saw when Russia invaded Ukraine bond prices rose and equity prices fell. If more Covid restrictions were to be introduced, then bond prices would likely rise. That is why there is always a role for bonds in portfolios, even if some of the traditional income characteristics are not there any more.” 

The problem is the more risk you take, the higher the correlation to equities, and in that scenario you have to ask yourself, what are you trying to achieve?Eren Osman

Eren Osman, co-chief investment officer at Arbuthnot Latham, says: “With bonds, the risks are higher, and the returns are lower than in the past. The diversification effects are reduced.

"The problem is the more risk you take, the higher the correlation to equities, and in that scenario you have to ask yourself, what are you trying to achieve? Is it about getting the diversification, or is it about getting the returns, because right now that is the choice, and it is important to know what you are trying to achieve."

The problem, says Sebastian Mackay, multi-asset investor at Invesco, is that bonds and equities can be expected to move in precisely the same way in a market environment where interest rates are rising and inflation is high, so the inverse correlation that underpins the investment case for most bonds fails. 

Bond yields rise (and so bond prices fall) when inflation is high because the real value of the future income from the bond is eroded. Additionally, if the base rate increases, this will cause the interest rates paid on cash to rise, making the interest rate from bonds less attractive. 

Most equities suffer in the same environment as higher rates would be expected to dampen the level of economic growth in the economy, and so, depress profits. 

Mackay does have some bonds in his portfolio, but says: “They are not the only defensive asset there now. We have also been buying currencies and even some more equities in order to protect against inflation. The reason inflation is a big concern now is people are more worried about inflation than about their jobs, and that tends to mean that inflation persists.”

Esoteric bond market

John O’Toole, multi-asset investor at Amundi, says the problem with owning bonds for defensive purposes in portfolios runs deeper than just the present levels of yield or inflation risks.

He says the lesson of recent years is that government bonds, even those in developed markets, have become “a volatile asset class”, with prices gyrating sharply in response to world events. O’Toole says this reduces the appeal of government bonds as a diversifier, and adds that corporate bonds tend to have higher correlation with equities. 

The fund manager says investors seeking to own bonds are now required to either take more credit risk or “do more esoteric things than in the past, such as owning, for example, emerging market debt or high-yield bonds”. 

McIntosh-Whyte is another multi-asset investor looking to somewhat more esoteric parts of the bond market right now. 

He says that instead of the government bonds of the UK and US, which may have been in portfolios historically, he is looking to invest in the debt of Canada and Australia right now.

This is because those countries are commodity exporters and so would expect to do well in a world of higher inflation. If those currencies rise in value relative to sterling, then the real spending power of the income rises, as there is a benefit from the currency movements.

He has also looked at emerging markets, where there is a potential for capital gains. This is because many emerging market economies have put rates up already, and their next move may be to cut rates. In that situation one could receive quite a high yield now, but also potentially a capital gain if emerging market economies cut rates during the period prior to the bonds maturing. 

Investors seeking to own bonds are now required to take more credit risk or do more esoteric things than in the past, such as owning emerging market debt or high-yield bonds.John O'Toole

Emerging market economies could cut rates if the global economy takes a downturn, and particularly if, having put rates up to curb inflation, developed market economies subsequently loosen monetary policy to stimulate growth. 

Central to the bear case for bonds right now is that, whatever the economic outlook, a decade of central bank policies made the asset class very expensive, and as such policies unwind, prices will fall and yields will rise.

But Tony Carter, multi-asset investor at Sarasin and Partners, says that longer-term and more profound factors than just monetary policy are behind the bull market that bond investors have enjoyed for most of the past 40 years. 

He says ageing populations spending less and saving more – creating a savings glut whereby a significant portion of the capital ends up in the bond market – the impact of technological change, and the globalisation of trade, mean inflation will be structurally lower over the long term than has been the case in the past. Consequently he says bond yields will be lower, and prices higher.

Carter’s view is that all of those structural factors remain prevalent in the global economy, with the possible exception of globalisation, which may be reversing, and all are supportive of bond prices over the longer term.

david.thorpe@ft.com