Building a diversified bonds portfolio

What role can government bonds play in your portfolio?

On the surface, the direction of government bond prices is pretty clear-cut in the coming months and years.

As governments in the UK, Europe and the US commit to spending billions on shielding populations from the straddling rise in energy prices, that cash will have to come – at least in the short-term – from issuing more bonds, thereby increasing the supply of the asset class. 

That is happening at the same time that, bewitched by inflation, central banks are restricting or ending their bond-buying programmes – a process known as quantitative tightening, to distinguish it from quantitative easing.

This was the programme instigated by policymakers in the aftermath of the global financial crisis, when they bought hundreds of billions of dollars worth of fixed income securities.

So with supply increasing markedly at the same time that a significant buyer of the asset is exiting, the intuitive response from advisers and their clients is to think that prices must fall from here.

If government bonds are about to fall from here, it will make a frustrating period for investors in the asset class. Quantitative easing contributed to a decade where the yield, or income, available from government bonds was meagre. 

Now yields have risen, with the UK 10-year gilt yield hitting levels not seen for a decade, but to access that income the risk is that clients would have to tolerate a capital loss, and certainly a lot of volatility. 

The factor most likely to make government bond prices rise is an economic downturn, as markets would then begin to anticipate central banks cutting interest rates, and buy the government bonds issued today, to lock in the income available at today’s higher interest rates.

Bonds and equities

It is from this principle that the idea of the inverse correlation between bonds and equities arises.

It is a correlation that has been challenged by the events of the past 15 years, initially as QE caused bonds and equities to rise in tandem, and then, more recently, the unwinding of QE contributed to the situation where those asset classes fell in tandem. 

If such an inverse correlation no longer exists, and given the fundamental supply and demand imbalance, is there a role for government bonds at all?

And while sovereign debt is just one area of the bond market advisers can access on behalf of clients, what happens to gilts then impacts the pricing of the rest of the asset class – and an investor choosing corporate debt instead is taking on more exposure to the performance of the wider economy.

Diversification

So what does a diversified fixed income portfolio look like right now? 

Colin Graham, head of multi-asset at Robeco, says the traditional inverse correlation between bonds and equities will likely return as QE is dismantled, and this reasserts the role of government bonds in a diversified portfolio; clients can expect government bonds to perform well, in price terms, if a recession occurs and equities are declining in value. 

The present lack of inverse correlation is because investors are focused on inflation, Graham says, but as they focus on recession the picture will likely change. 

Andrew Balls, chief investment officer for global fixed income at Pimco, says he has been adding government bond exposure to the balanced portfolios he runs.

Balls is moving from an underweight position to something closer to a market neutral one.

He says the primary reason for this is the higher yields available, though he also expects a recession to occur in the US, UK and Europe, and in such a climate, prices would be expected to rise. 

Rob Burgeman, investment manager at Brewin Dolphin, has not made a call on the likelihood of recession, but has been buying more government bonds anyway – his view being that at present levels yields pay an attractive enough income. 

As the yields on government bonds have risen, so have the yields on corporate bonds.

But Chris Higham, who runs the Strategic Bond fund at Aviva Investors, is maintaining his stark underweight position to government bonds.

He accepts the view that the price of such assets could rise in the event of a recession, but says: “You shouldn’t buy something just because of a recession. The key would be the depth of the recession, that is what would influence the price of government bonds.” 

Jon Jonsson, fixed income investor at Neuberger Berman, says one option for investors looking for diversification from their government bond exposure is bonds of countries such as China, where the economies may be moving in a different direction to that of the rest of the world.    

Risk waiting 

The challenge bond investors face, according to Ed Craven, fund manager at Invesco, is to decide whether to protect against inflation (known as duration risk) or to protect against recession risk (known as credit risk).

If one’s priority is protection against inflation, then the typical approach is to own bonds with a short date to maturity, as the income from these, and therefore the price, is more protected from rate rises.

By contrast, if a market participant takes the view that recession is the greatest source of risk, then the traditional approach is to buy longer-dated bonds as in the event of a recession the market’s view would be that interest rates will be cut. 

In such a scenario, the longer the date to maturity of a bond in existence today, the greater capacity there is for that bond to rise in value in price terms, as it locks in the interest rate paid on today’s bond into the future, even if interest rates fall.

Craven says his view and that of his colleagues in recent years has been that interest rates may rise, so the primary risk to protect against in bond markets was inflation, and that was one of the reasons bonds have struggled generally this year.

Craven runs a multi-asset income fund at Invesco, and so can choose to invest in bonds or not. In recent months, as bond prices have fallen, he has begun to buy more, specifically selling off some of the equity investments in his fund to do this. 

He says government bond prices have fallen to such an extent that “they are now pricing in quite a few rate hikes, so protection from those seems less important than before”.

Craven has also begun to increase the level of credit risk in his bond portfolios, partly because selling off equities reduces risks on that side.

He says one of the challenges of owning government bonds over the past year or so is that even in developed markets volatility has been high, and one of the traditional reasons for owning government bonds, as a hedge against volatility in a balanced portfolio, has been diminished.

Gopi Karunakaran, co-chief investment officer at Nordea Asset Management, says the key to understanding the diversification benefits of government bonds is that in normal times the yields are high immediately prior to a recession, and as investors exit the most economically sensitive assets and buy bonds, the yields fall, and the prices rise.

He notes the problem with such a plan over much of the past 15 years has been that government bond prices were already so high that one had to take on considerable risk to buy them.

But Karunakaran adds that government bond prices having fallen so far this year that the yields are now sufficiently high as to restore those historic diversification benefits. 

High yield 

At the other end of the spectrum from government bonds are high-yield bonds. They are at the opposite end of the spectrum because they typically have almost the same economic sensitivity as equities.

But this should not detract from the investment case, according to Balls, who says investors should focus on the returns available from this part of the market rather than the diversification element.

He says that rather than trying to decide whether one wants bond exposure that protects against inflation or recession, “it is possible to do both.

"You can do it because the shock that is impacting the UK economy and bond market is impacting other markets.

"But in terms of the attractiveness of high-yield bonds, we are being careful now in the portfolios I run, but in the higher risk portfolios we have increased our high-yield exposure."

Aviva’s Higham says that with valuations where they are, “it would need to be a very deep recession to justify being underweight on high-yield bonds right now.

"We are neutral on high yield right now. The thing is, companies have been doing the right things in recent years, paying down debt and so are in quite a healthy place."

Brian Nold, a portfolio manager at Muzinich & Co, puts some context around the health of the high-yield market. 

Despite that being the area where the risk of default by the companies borrowing should be highest, Nold says the long-term annual average default rate is 3 per cent of the bonds issued, while at the present time, default rates are at just 1 per cent.

Eleanor Ingilby, deputy head of portfolio management at Atomos, says that while the price of a bond may fall, a client invested for income does not necessarily need to care about this, as long as they continue to receive the income. 

Ingilby says high-yield bonds look attractive right now. “Investors who can ignore the mark to market moves and who purchase investment-grade bonds to hold to maturity are locking in fairly certain returns of around 5 per cent in the UK.

"Even if the inflation monster remains free, 5 per cent annually goes some way to mitigating its ravaging effect.

"When the bond eventually matures, if inflation is still wild, then bond markets are likely to have adjusted further, perhaps giving you the chance to reinvest at 10 per cent. Unless hyper-inflation sets in, bonds still provide a lower risk option to mitigate the inflation pain."

david.thorpe@ft.com