Revisiting bonds for multi-asset

The last decade has seen a growth bias among financial assets, one that has become entrenched in equity indices. At the same time, bonds seemingly shed much of their protective qualities, offering investors very little by way of diversification.

This came to a head in 2022, a year that saw one of worst bond market sell-offs in a generation after central banks aggressively raised interest rates to contain inflation. Bonds and equities fell in tandem, bringing into question the merit of bonds as a diversifying asset class in a traditional 60% equities/40% bonds portfolio.

It is largely for this reason that until recently we had very little exposure to bonds in our mixed-asset portfolios. But the outlook for the asset class has changed. We now see bonds offering higher yields and providing better diversification as part of a multi-asset portfolio. We’ve even gone so far as to herald the ‘rebirth’ of the 60/40 portfolio.

In this changed environment, we see potential to make decent returns in the bond market. The pivotal factor remains central-bank policy and how far interest rates will have to rise to bring inflation back down. Given the pace of rate rises to date, it may well be that policymakers push too far, creating a slower economy than perhaps people will be expecting and, with it, a slowdown in consumer spending.

Expectations at the end of last year were broadly factoring in widespread recessions in 2023. It typically takes nine to 12 months for interest-rate changes to feed into the real economy, but we think it may take longer. In the UK, people had been moving onto longer-dated five-year fixed-rate mortgage terms,¹ taking advantage of historically low interest rates in recent times, so it may take longer to see higher interest rates affect consumer spending.

It could take even longer to play out in the US, where 30-year fixed-rate terms are the dominant mortgage product,² protecting disposable income for people with these long-dated mortgages. In addition, older generations typically do not have mortgages and are benefitting from higher interest rates on their savings, boosting their spending power.

Furthermore, the combination of real wage strength – keeping pace with inflation – and high household savings has resulted in a lag in the true effects of higher interest rates on the real economy. The real-world impact of monetary tightening isn’t quite biting yet, but we expect to see these effects starting to take hold by the end of this year.

When the economy does eventually roll over, it could create an environment in which equities do less well. In this scenario we think government bonds should offer better diversification, particularly in relation to their plight in 2022. As such, our mixed assets team has gradually increased its weighting to government bonds and, to a lesser extent, to corporate bonds.

We have also reduced the exposure to alternatives, choosing to reallocate resources up the capital structure in the bond market, given bonds’ attractiveness as an income-producing investment.

Overall, we believe bonds are buyable again, both in terms of their potential to generate returns and for diversification purposes. In our view, they should once again play a role in a well-diversified portfolio, one that also keeps exposure to growth opportunities within equity markets, and to real assets that can provide an attractive level of yield in the inflationary environment.

Sources:

[1] JP Morgan. First Principles – UK Mortgage Market, Europe Equity Research. 8 June 2023

[2] Journal of Real Estate Practice and Education. The Dominance of the US 30-Year Fixed Rate Residential Mortgage. Richard J Kish (2022)

Authors

Paul Flood

Head of Mixed Assets Investment