Alex Funk, chief investment officer at Schroders Investment Solutions, says the present level of inflation in the economy should not mean abandoning any long-term asset allocation structure, but does mean moving allocations around “within asset classes”.
Higher inflation is, of course, typically very bad for bonds, as has been seen this year with the IA Sterling Corporate Bond sector losing more than 9 per cent, a performance worse even than the returns of a money market fund, which just holds cash.
And, unlike with some parts of the equity market, the type of inflation percolating through the economy is largely irrelevant to the bond market, all inflation is a negative.
But Funk says that while most of the focus is on the supply-side inflation, he says there is some demand-side inflation in the economy as well, and the latter means that more economically sensitive areas of the bond market, such as high yield, can perform well.
He says the inflation has probably reached its peak and will start to come down in the months ahead, which is also likely to boost bond returns.
Those areas of the bond market are also interesting Bryn Jones, head of fixed income at Rathbones.
He says that while a recession “is a possibility” it is not a certainty, but bond markets are presently pricing in a very severe economic outcome.
He says in the investment-grade bond universe, that is, bonds with a credit rating of BBB or higher, bonds in aggregate are presently priced as though 6 per cent of them will default on payments, while Jones says the historic average default rate in this area of the bond market is around 1 per cent.
Jones adds that high yield bonds, that is, those with a credit rating of below BBB, are priced to reflect default rates that have not been seen since 1970.
While keen not to make an economic forecast, Jones says: “A recession might happen, but it is not a given. Unemployment is very low, while Purchasing Manager Index (PMI) survey data is in positive territory (indicating economies are expanding), and in that climate one would have to say that a lot of bad news is priced into bond market valuations.”
Of course, from an income perspective, it is the level of yield that matters to investors, and while bond yields have risen this year, inflation has risen even faster, meaning bond yields remain negative in real terms, that is, the yield is lower than inflation so the spending power is diminishing.
Specifically with regard to government bonds, many regard them as a sort of portfolio insurance, a position held on the basis that government bonds, in particular, are likely to perform better in the event of equity markets under-performing.
The challenge for investors over the past decade has been that while the bonds may act as insurance in times of strife, the yields on those assets have been very low, or even negative, even before inflation was considered.