The role of government bonds in an income portfolio

A hint to the answer to that came with October’s very sharp bout of volatility in government bond markets, which peaked with the yield on some US government debt reaching a 17-year high, as governments seeking to borrow money to fund spending plans find they are competing for capital at higher interest rates than has been the case for a decade, and without having the central banks in the market as major buyers of the debt. 

Collapsing prices of course mean higher yields, and therefore the asset class may be more attractive to investors with income as a focus. 

On the other hand, government bonds are typically placed into portfolios with a remit to dampen the volatility associated with equities and equity-like investments. 

So if government bonds are going to contribute to volatility, what role can they play in a fixed income portfolio? 

Alberto Matellán, chief economist at MAPFRE, says the change investors are trying to digest right now is not simply that we are transitioning away from a decade where rates were low, but, in reality, a “40-year period where inflation was mostly coming down, and bond yields were coming down. In the past two years we have had a situation where government bonds have gone back to the level they were 15 years ago, it’s a huge transformation.”

Throughout 2022, markets woke up to the fact that government bonds could also be a source of risk and significant drawdowns.Thomas Gehlen, SG Kleinwort Hambros

Higher bond yields of course mean lower bond prices, and in more normal market conditions a decline in the expected level of future economic growth would usually be expected to cause investors to rush for the safe haven of government bonds, pushing the yields down and the prices up.

That introduces the potential for capital appreciation from bond holdings, but would also reduce the income available to those who have that priority.

A PIMCO representative says: “When rates were very low, investors lost some of the diversification benefits that people look for in fixed income. We saw this happen in 2022, with some painful losses in both the bond market as well as equity markets.

"Where we are today and looking forward, the good news is that with government bond yields much higher you now get that diversification benefit and the opportunity for an attractive total return."

Matellán says one of the reasons for the profound market sell-off in October was the market revising its expectations about the outlook for inflation and economic growth. 

Due to the market had started to expect an economic deterioration, bond prices had begun to reflect market expectations that rates would soon be cut as inflation fell. 

Lower rates would mean the coupons available on future government bonds would be lower than those on current bonds, offering the potential for capital gains, while if inflation does fall, it increases the purchasing power of the yields earned on bonds, potentially making them more attractive as an income investment.

Bryn Jones, fixed income director at Rathbones, says he expects the downturn in growth to occur next year, and with that in mind he has been buying longer-dated government bonds.

Thomas Gehlen, senior market strategist at SG Kleinwort Hambros, says that following a period where he was extremely sceptical about the investment case for government bonds, either as a diversifier or as an income investment, he now views the recent price falls as an opportunity.

He says: "Throughout 2022, markets woke up to the fact that government bonds – traditionally defensive assets – could indeed also be a source of risk and significant drawdowns.

"With interest rates now back to pre-financial crisis levels however, this risk has abated somewhat, and government bonds have reclaimed their traditional characteristics of both protection and income.

"Where there was a Tina (or 'there is no alternative') sentiment driving investors to riskier assets such as corporate credit or equities to achieve acceptable income yields, these can now be comfortably attained with larger exposures to sovereign debt."

Gehlen adds: "As 2022 has shown, gilts are not as risk-free as academia would suggest, but yields are likely closer to their top than their bottom, and the convexity of duration suggests that the pain from any further yield rises should be less than it was a year ago – a jump from 5 per cent to 6 per cent is much less significant than one from 1 per cent to 2 per cent."

Howard Cunningham of Newton Investment Management is another investor who views the recent changes in the bond market in a positive light, noting that at previous price levels government securities were effective neither as an income investment nor as a diversifier.

But he says that gilts (and other G7 bond markets) certainly offer more enticing yield now. The gilt market average yield is now about 4.7 per cent compared to just 1.6 per cent average over the past decade.

Matthew Rees, head of global bond strategies at Legal and General Investment Management, says one does not even need to have a strong view on the direction of interest rates, inflation or other market factors right now to view short-duration government bonds as attractive.

He says: “You can get 5.5 per cent on a very short-dated gilt, being short duration means you don’t have to concern yourself as much with interest rates.”

Having been short duration, Jones says he is gradually increasing the duration in his government bond allocation in anticipation of an economic downturn next year. 

David Thorpe is special projects editor at FT Adviser