Diversifying your bond portfolio for income

The dilemma is also central to the thoughts of Brian Kloss, fixed income investor at Brandywine, who says: “The narrative around the bond market is changing very rapidly, the topicality is immense. The issue most of the time is whether the central banks are putting the accelerator or the brake pedal down.

"And in the US during the pandemic, they put the gas pedal down, and what we have seen recently in terms of volatility has been a function of the brake being applied."

Usually in the latter stages of the 'brake' being applied, bond investors buy longer-dated bonds, as these usually perform best when inflation and economic growth are both declining.

But this has not been the case of late, as investors have rapidly revised their expectations around the extent and timing of US inflation returning to target.

While such moves enhance the case for diversification within a fixed income portfolio, Kloss says that rather than taking any outsized positions in the name of diversification right now, when people are unsure as to what risks one wants to diversify against, he is instead focusing on owning government bonds.

These are "at the short-end of the curve where the yields are good, and a little bit in the [middle] of the curve" – this part of the curve would be less sensitive to a recession shock than the start of the curve – "and then just wait and see what happens".

Matthew Rees, head of global bond strategies at L&G Investment Management, is of the view that one should always diversify regardless of what asset class is involved, and even if this means occasionally accepting a lower yield.

But he notes that the spread – that is, the difference in the yield level between one type of bond and another – is presently high enough to justify owning bonds with a higher credit risk, as the yields are attractive enough.

He said this may represent some diversification away from government bonds, while also providing a higher income yield for those clients with that as a priority.

Rees says there has been considerable disquiet around the prospects for high-yield bonds due to fears around the implications for the issuers of such debt when they come to refinance at much higher rates, and then default on their obligations. 

But he says fears here are overstated, as many of the companies that issue high-yield bond did so during the pandemic and have many years yet to run on those bonds, locked in at low interest rates. 

With this in mind, he says there is some value to be had from high-yield bonds as a diversifier right now, particularly as the yields are sufficiently high that they compensate for some capital loss, if the latter occurs. 

A representative of PIMCO says they believe the key is to invest in strategies that have the flexibility to invest across the full range of fixed income markets. 

They say: “Multi-sector strategies that have the flexibility to invest across a range of sectors, geographies, credit qualities, and maturities allow you to diversify a bond portfolio.

"[By] balancing higher yielding and higher quality assets that perform differently in varying growth environments, opportunities can be accessed around the world no matter which way the markets and interest rates move. This can provide attractive income potential while maintaining a close focus on risk."

Haig Bathgate, head of investments at wealth manager Atomos, says with government bonds yielding 5 per cent, compared to the long-term average return from equities of 7 per cent to 8 per cent, "it's a no brainer to have government bonds in a multi-asset portfolio".

"But the other thing that has changed is that, for the first time in 20 years you can get an income from bonds. If you are looking at the bonds with more credit risk though, you have to ask yourself, are you getting paid enough for the extra risk? Especially when you consider that you need to have some income growth in portfolios, and that is what equities can provide.”

Multi-sector strategies that have the flexibility to invest across a range of sectors, geographies, credit qualities, and maturities allow you to diversify a bond portfolio.Pimco

Rathbones' fixed income director Bryn Jones says his way of solving the above conundrum is to be long duration on the government bond exposure and short duration on the bond with the greater credit risk.

This is because he feels that longer-duration bonds should offer protection from an economic downturn, while those with more credit risk are shorter duration, but offer a higher yield, to ameliorate this. 

Jamie Niven, fixed income investor at Candriam, says the longer-term path is for inflation to be higher than many investors had become used to, however due to the impact of the aggressive hiking cycle, he favours holding duration right now. He adds that one of the risks which investors with income as a focus face is that they buy higher yield and risk the capital value of the bond falling.

In contrast, he says that owning government bonds may deliver a capital return next year, even if the yields are lower. 

Kevin Thozet, who is part of the investment committee at Carmignac, says the sell-off in long-dated government bonds now “more than reflects” the changed inflationary environment – essentially his view is that the opportunity for capital gain is now in this asset class.

David Thorpe is special projects editor at FT Adviser