What role will fixed income play in portfolios?

But as 2022 gave way to the new year, the oldest adage of the lot in bond markets – that yields rise as prices fall – took hold, and investors began to creep back into the asset class in order to pick up the income. 

Edward Craven, bond investor at Invesco, traces the causes of last year’s rout in the bond markets as the result of central banks underestimating inflation, and then having to react very rapidly. 

That led to bonds selling off very quickly. 

As the new year hangovers faded from memory, the momentum towards bonds gained further ground as investors begun to prioritise recession protection over inflation protection, creating a desire to own bonds for reasons of capital gain, as well as income accrual. 

Being underweight duration was the key call for bond investors to get right.Bryn Jones, Rathbones

As we approach the second half of the year, some of the economic data emerging from developed markets has been more positive than expected, but inflation has also been more persistent, bringing into still further light questions around the role of bonds in portfolios. 

Bryn Jones, head of fixed income at Rathbones, says: “Last year being underweight duration was the key call for bond investors to get right.

"That would be expected to recede if a recession comes, but what we have seen so far is a strange combination: inflation has stayed high, which is usually what would make an investor go short duration, but economic growth has been OK. But I think in the next six months you are going to see some sort of slowdown.”

A feature of much of the economic commentary right now is the notion that we could have an earnings recession, that is, company profits slip to levels commensurate with an actual recession, but the wider economy avoids this fate. 

Jones says that while he expects a slowdown, he is unsure how broad-based it will be, but is staying “in safer waters” for now. 

To him that means owning long-duration government bonds, as those assets would usually expect to rise in value as “safe havens” in the event of a deep economic downturn. 

But in the corporate bond universe, he is focused on shorter duration assets, as he can pick up decent yields and the bonds may have matured before any downturn occurs.  

What is different now is that, because central banks are not there to support government bond markets, they will be much more volatile going forward.Paul Grainger, Schroders

Paul Grainger, global head of fixed income and rates at Schroders, says as the US was the first economy to begin materially increasing interest rates, the key for investors is to look at what happens there.

He says: “It has never been shown anywhere that monetary policy doesn’t work, but the timing of when each country feels the impact is harder to quantify.” 

Right now his focus is on long-dated bonds, but he says if short-dated bond yields were to rise materially from here – an event that would likely be the consequence of inflation expectations among market participants moving sharply downwards – then he would likely increase his exposure to short-dated bonds, as the yields would be more attractive.  

He says a key consideration for investors in the year ahead may be that government bonds “are back as a safe haven, with yields where they are, the likelihood is that in the event of a big sell off in equity markets, government bond prices would rise.

"But what is different now is that, because central banks are not there to support government bond markets, they will be much more volatile going forward.” 

His view is this will lead to a greater “flight to quality” among investors as they seek to minimise the volatility.

This is a particularly existential question for investors, as many when constructing a portfolio deliberately include government bonds as a way of reducing the volatility inherent in equities. 

In the next six months you are going to see some sort of slowdown.Bryn Jones, Rathbones

Phil Milburn, fixed income investor at Liontrust, says one feature of the decade during which central banks rabidly interfered in bond markets, was that most of the returns generated from the asset class came as a result of rising prices, with the income yield available falling. 

But he feels that in the new world of central banks moving away from QE, the bulk of investment returns will come from the income on bonds. 

And that changes the role bonds can play in portfolios, particularly if a client does not have income as a priority. 

More broadly, he says he has begun to buy investment-grade corporate bonds because he thinks, even in the event of a recession, the default rates among bond-holders in that part of the market tend to be very low, but the yields right now are quite high. 

Craven says he is finding value in high-yield bonds and among the lower end of the investment-grade bond universe, as he feels that even if there is a recession, default rates, at least in the coming year or so, will be sufficiently low, and given how high yields are, he feels this is worth the risk.

Edward Harrold, fixed income investment director at Capital Group, says the performance of high-yield bonds has been strong in recent times because they also tend to be short dated. 

He is wary of moving into longer duration bonds right now in case inflation persists, and takes the view that if one wants to diversify, the economic and market conditions present in emerging markets are sufficiently different to those in developed markets that the outcomes and drivers of investment performance will also be different.

David Thorpe is investment editor at FTAdviser