The role of government bonds in portfolios

Paillat, portfolio manager at Aviva Investors, says: "Bonds have been doing worse than equities this year. At the moment gilts are falling and catching up, or catching down, with the falls that happened to US Treasury bonds earlier this year.”

The heightened volatility this year means that “government bonds have, for me, moved from being a strategic part of the asset allocation to being a tactical asset, one that you own only when valuations are right,” says Shaniel Ramjee, senior investment manager at Pictet Asset Management. 

He cautions investors not to repeat the mistakes many made in the 1970s – the previous period when inflation rose sharply and suddenly and bond prices fell.

The wider picture is that economies globally are increasingly marching to their own drumbeat.Anthony Rayner, Premier Miton 

He says: “When yields began to rise, people’s initial reaction was to look at the extra income they were getting, rather than the capital loss that was occurring in their portfolio, and that happened for years, and every year they thought they were doing better, until they realised they weren’t.

"I think the option for clients now is to think about investing in a wider range of government bonds and regions, because the next stage of the cycle is likely to involve a greater divergence in how the bonds of different countries perform, and that could represent an opportunity. Currency is also relevant when you are considering buying.”

Anthony Rayner, multi-asset investor at Premier Miton, says: “Central banks continue to drive markets but, importantly, in a very different way to the past 30 years. The wider picture is that economies globally are increasingly marching to their own drumbeat. 

"As rates move higher, so a country’s imbalances become clearer. For example, higher rates bring into focus the degree of fiscal imbalance and specifically the higher cost of government borrowing. 

"This is in stark contrast to the co-ordinated lower rates that characterised much of the globalisation years and which helped to soften the differences between economies and their financial markets.”

Price of bonds

That is a journey that James Beaumont, multi-asset investor at Natixis, has already been on. He took the view several years ago that bonds were generally over-priced, and so went profoundly underweight relative to the index, but he is starting to find them more interesting as a potential investment now.

He says: “We took the view, when government bond yields went literally below zero, that it could not continue. We didn’t know what the catalyst would be, but we thought it had to change. And that view hurt us in our portfolios for a long time, but it has worked a bit this year.

While we are not out of the woods yet, it may be that inflation is close to peaking.Simon Holmes, Columbia Threadneedle

"As yields have risen, it has become a major topic of discussion within our investment committee [whether to increase bond exposure]. My view right now is that it’s too early to do that, but it is an ongoing discussion.”

Simon Holmes, multi-asset investor on the Universal fund range at Columbia Threadneedle Investments, says: “Bond prices have been falling this year in response to higher interest rates, and that makes sense. I have been negative on government bonds myself for most of this year.

"But now I think it is more of a two-way debate. Yields are higher, which of course is more attractive, but also, we have a clearer idea now of what it is central banks care about. It is a relatively swift capping of inflation that central banks want.

"And while we are not out of the woods yet, it may be that inflation is close to peaking. There is also the issue of quantitative tightening, and there is uncertainty around that. But I think the market is aware of that, and it may be in the price to some extent.”

The extent to which markets may already be pricing in the range of negatives associated with bond investments can be seen in the “cushion” offered by government bond yields right now, according to Fahad Hassan, chief investment officer at Albemarle Street partners.

It’s difficult to get excited about government bonds.James Klempster, Liontrust

By this he means the yields are now sufficiently high as to provide a bit of margin of error in case the direction of travel in markets changes. 

He says that as inflation peaks in the next “12 to 18 months”, investors will be able to access “massive real yields". 

UK vs US

Holmes says there is little difference in the levels of volatility between the US and UK government bonds right now, but he says the government’s energy price policies may mean inflation peaks at a much lower level than had previously been anticipated, placing a limit on how high bond yields in the UK can go from here. 

Kevin Thozet, portfolio adviser at Carmignac, says it is now possible to get yields in some government bond markets that are higher than the prevailing rate of inflation, making the yields, mostly in the US, positive both in real and nominal terms. 

James Klempster, multi-asset investor at Liontrust, says: “It’s difficult to get excited about government bonds, the price is now close to 2011 levels. They are more interesting, but it would be a stretch to call them cheap. The reason we own government bonds is as insurance in a portfolio. They are not owned for a return.

"For the past decade, you couldn’t create inflation no matter how hard you tried. Now inflation is biting and interest rates are moving up, it's been a difficult time to invest in them, but prices have moved back to a more reasonable level.

"In the short term bonds haven’t offered meaningful diversification but over the long term they will provide it.” 

david.thorpe@ft.com