Bonds have had a difficult few months, particularly as inflation expectations have climbed. So why does Nutmeg still hold them, and what role should they play in diversified portfolios?
In simple terms, bonds are debt instruments that pay investors a steady stream of income in return for their cash up front. Income however is only a small part of the story, with multi-asset investors having benefited from the diversification advantages of this asset class, which historically has a low correlation to risk assets such as equities.
Why invest in bonds
The importance of bonds as a long-term hold in multi-asset portfolios cannot be understated, especially over the past 20 years given an attractive risk/return profile. A ratio of return over volatility is a useful measure to assess the appeal of an asset class. Typically, the higher the ratio, the more attractive as it will be due to high returns and/or low volatility. With government debt, the ratio has been close to 0.8 for US treasuries and 0.7 for UK gilts, which is attractive.
In comparison for broad equity indices, such as the MSCI World, the return over volatility ratio has been around 0.5, and even 0.35 for UK large-cap indices. It means that on average equities tend to be twice as volatile as government bonds when generating a similar level of returns.
In terms of risk adjusted-returns, government bonds have been one of the most attractive asset classes to hold long term. While returns have been lower than equities, there’s been less volatility too. The long-term volatility of UK gilts over the last 25 years is around 6.5%, which contrasts to equities where returns have been higher but with much higher level of volatility (14% to 15%).
Given these qualities, bonds have traditionally been a strong asset to hold during equity drawdowns. Taking the worst months for the S&P 500 over the past 15 years (months where the S&P 500 lost in excess of 2%), UK gilts generated positive returns of 78% in those months with a median return of 1.5%.
Few asset classes have managed to perform similarly with only the Japanese Yen versus Sterling, the US Dollar versus world currencies, and to a smaller extent, gold, offering similar positive returns during times of equity market stress.
In general terms, bond markets have on average been negatively correlated with equities and other risk assets – bonds typically perform well during periods of poor equity returns, and vice versa.
In the context of multi-asset portfolios, efficiently mixing bonds and equities, with one mitigating the potential loss of the other, has historically provided solid portfolio efficiency with attractive risk-adjusted returns. However, recent months have seen something of a break from the norm…
So, what’s happening this year?
Having made a case for the long-term attractiveness of bonds, we cannot gloss over the recent performance of the asset class which has flattered to deceive since around September 2021 and accelerated on the downside in the first quarter of 2022.
From a macro perspective, the third quarter of 2021 saw something of a shift in sentiment from professional investors with a growing belief that inflation was likely to remain higher for longer than initially anticipated. This shift in belief was shared by all-important policy makers, with the US Federal Reserve (Fed) in particular reversing its initial forecasts which had the current inflationary environment described as as “transitionary” trend. Consequently, central banks’ initial strategy for a very gradual removal of accommodative monetary policy (rising interest rates) shifted to a faster and sharper normalisation process.
Bond yields reacted accordingly, anticipating a much faster normalisation process. As bonds total return is inversely related to yield movement, bond performance has been negative with losses larger than those typically experienced during short-term drawdowns over the past 40 years.
While Russia’s invasion of Ukraine has understandably caused some volatility within equity markets in recent weeks, bonds have also uncharacteristically taken a downturn. When looking at bonds, investors take into account both the potential yields (the interest paid by the issuer of the bond) and capital appreciation (the price of the bond, which is negatively correlated to yield).
During the pandemic, central bank action in supporting the economy pushed interest rates and bond yields lower with an objective to stimulate the economy. With yields at extremely low levels following the worst of the Covid pandemic, it was expected that bond yields would ultimately increase to more “normal” levels as the economy recovers. However, with the pandemic still dominant throughout 2021, the speed of future normalisation was seen as uncertain and the belief was central banks would be patient to normalise. This expectation has clearly reversed in the first quarter of 2022.
At this point, it is also worth highlighting normalisation is rarely a linear journey and difficult to anticipate perfectly. For example, while most bonds sold off in January 2021, global government bonds performed strongly between February 2021 and August 2021 as the world was still largely impacted by new waves of Covid and lockdowns.
How we’ve been managing bond exposure
In all of the Nutmeg portfolios, to reflect our negative view on bonds, exposure has been lower than our long-term neutral since 2020. Since mid-2021, we have used proceeds from the reduction of our fixed income exposure to raise our cash levels, especially so in medium-risk portfolios. While this approach has been beneficial, clearly it wasn’t enough to completely protect the portfolios from a bond sell-off, with a negative quarter for equities in the first three months of 2022 also dragging on performance.
We have been overweight equities and underweight bonds for more than a year, with this positioning having been largely beneficial for our investors in 2021. For now, we maintain our view that bonds are not attractive especially versus equities over the medium term.
On a short-term basis, this stance has been challenged given the underperformance of both bonds and equities in the first quarter of 2022. However, given our belief that equities are likely to outperform bonds in the medium and longer-term, this may make lower-risk portfolios with more bond exposure less attractive than higher-risk portfolios more heavily invested in equities, despite the latter being more volatile and carrying higher risk of larger drawdowns.
As a team, we actively monitor bond performance and yield levels daily. With mid-term bond yields in the US at around 2.5% at the end of March 2022 and gilts at 1.7% in the UK, it is clear that much has changed already compared to when bond yields bottomed out at 0% in March 2020. While there’s a reasonable chance to see yields climb higher, the path is unlikely to be as sharp as it has been in the past six months with yields starting to become more attractive, especially if inflation was to cool down a little.
Forecasting bond returns has and will always be a difficult exercise, as this quote from FT.com taken from a May 2018 article reminds us: “As global monetary policy tightens and central banks promise further interest rate rises, many commentators have called the end of the 36-year bond bull market. The most popular fixed income funds are losing their lustre”.
While it could have been easily published in 2022, this 2018 article was published prior to a rally in bonds that saw US bond yields moving from 3% to 0.5% in the following two years and government bonds to rally almost 40%.
Even though we think we are in a very different situation today, especially with levels of inflation not seen for decades, we want to remain nimble. We manage our underweight exposure to bonds carefully in the context of long-term attractive risk-adjusted performance for the asset class.
In conclusion, we still find bonds to be lowly attractive currently versus other asset classes like equities. Translating this into portfolio management, we believe our higher-risk portfolios, despite their higher level of volatility, may offer more attractive absolute returns in the mid-term.
We remain cautious with our ability to be more aggressive in our underweight position to bonds and we believe our current exposure is appropriate across our risk levels. We will actively monitor it in the coming weeks and months and will adjust our portfolios, even tactically if needed, should risk/reward in bonds becomes more skewed in one direction or the other.
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance and forecasts are not reliable indicators of future performance.