Bonds repricing provides case for income we have not seen in a long time

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Bonds repricing provides case for income we have not seen in a long time
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Fixed income has traditionally helped to build resilience in diversified pension portfolios in times of elevated stock market volatility.

Bonds came to the rescue for multi-asset funds when stock markets fell in the dot com bubble of 1999, during the global financial crisis of 2008, then in late 2018, when trade tensions between the US and China escalated, and most recently at the outbreak of the Covid-19 pandemic in the first three months of 2020.

Government and corporate bonds have also served their purpose in risk-aware retirement strategies of helping to reduce the risk that customers are exposed to in the closing stages of their retirement savings journey by providing a modest but positive return. 

But since the start of the year and, in particular, in the three months to the end of June when bond and equity prices declined and the performance of equities and bonds has become more closely correlated, the traditional role played by bonds in a diversified equity/bond portfolio has been questioned. 

The very real risk of a recession means that central banks could at some point reassess their tightening cycle, which would support bonds.

We’re in a highly unusual market environment though, caused by an unprecedented set of circumstances: a persistent rise in inflation, accentuated by the conflict between Ukraine and Russia, has triggered fears of a global recession, all on the heels of a global pandemic.

There have only been three years in the past 45 years where global equities and bonds have sold off at the same time, as shown below.

Annual returns for global equities and bonds in U.S. dollar terms from 1977-2021 (Source: BlackRock Investment Institute with data from Refinitiv Datastream and Bloomberg, May 2022)

On this basis, we believe that the market dynamics for bond investors will reassert themselves eventually.

The very real risk of a recession also means that central banks could at some point reassess their tightening cycle, which would in turn support bonds.

Central banks have responded to the sharp rise in inflation by tightening monetary policy and so raising interest rates and paring back their bond-purchase programmes.

This stance by policymakers, while anticipated in 2021 and thus causing volatility in bond markets, nevertheless created a massive shock for markets and for the economic system after 10 years of record low inflation and interest rates, and the adjustments in bond prices since mid-2021 are a reflection of this. 

Central banks are caught in a tug of war, needing to fight inflation without creating more problems for the economy.

The International Monetary Fund, the World Bank and the OECD have all warned in recent months that we face a global recession due to the war in Ukraine. 

The US central bank has taken a more aggressive approach to raising borrowing costs than its peers, taking rates from near zero to a range of 2.25 per cent to 2.50 per cent since March, while in the UK, where rates are 1.75 per cent (as at time of writing), the Bank of England has been criticised for not acting sooner on inflation and also for not raising borrowing costs enough.

While it’s been a painful time for fixed income in the short term, we believe the re-pricing in bonds provides a more attractive case for income in the longer term.

The UK’s cost of living crisis means that recession fears, combined with a focus by the BoE on raising interest rates, have hit the UK fixed income market hard.

At Aviva, using all of the tools at our disposal in our bond armoury has been important here. More specifically, investing in short-dated bonds has enabled us to reduce duration and therefore our exposure to the worst-performing parts of the UK bond market.

In the first half of 2022, the ICE BofA Sterling Non Gilts Index declined 12.41 per cent, while the FTSE Actuaries UK Conventional Gilts All Stocks Index declined 13.90 per cent.

In comparison, the ICE BofA Sterling Non Gilts 1-5 Year Index declined 4.88 per cent, while the FTSE Actuaries UK Conventional Gilts Index declined 2.18 per cent in the first half of 2022.

Similarly, using tactical asset allocation at a regional level to avoid US government bonds, where the tightening cycle has been more aggressive, has also helped.

While it’s been a painful time for fixed income in the short term, we believe that the re-pricing in bonds that we have seen since the start of 2022, provides a more attractive case for income in the longer term, and one that we have not seen in a long time.

UK government bonds have drawn a lot of criticism for not providing yield-starved investors with an adequate level of income over the past decade, given the record-low interest rate environment and quantitative easing programme in place since 2009.

An increase in bond yields is also positive for corporate bonds. Strong research in the credit space to identify the best quality and attractively valued corporate bonds will be well rewarded here.

While there may potentially be more volatility in bond markets in the near term, we believe strongly that the case for strategically owning bonds over the longer term remains.

Government and corporate bonds have a role to play in managing inflation and duration risk, which is not possible through cash alone, and also where risk-aware investment strategies are used to take customers through their retirement journey.

Looking ahead, we believe holding both equities and bonds will provide our customers with the benefits of diversification.

Helen Delaney is investment proposition manager at Aviva Wealth