There’s no doubt that bonds are not looking particularly attractive at the moment. Whilst equities staged a partial recovery after their recent correction, bonds have not. In fact, taking the Bloomberg Barclays Global Aggregate as our reference, bond prices have been falling all year and even after factoring in coupons, investors are down about 2.5% from mid-2016 highs. These moves of course mirror bond yields, which hit lows in mid-2016 on deflation jitters compounded by a rush to safety after the EU referendum result. Yields have since moved upwards on the back of strengthening global growth, but they aren’t exactly at generous levels. The same inflation fears that spilled over into equities and caused the recent sell-off have pushed up US 10-year yields to just over 2.9% as of mid-February – above UK gilts and way above German bunds and Japanese bonds, but still at historically low levels.
Inflation, of course, is to most bonds what kryptonite is to Superman. Because their principal and coupons are fixed in nominal returns, inflation eats away at their real value and hence the real return of bonds. So recent inflation worries are concerning to bond investors.
So, should we pull the rip-cord on the asset class, fleeing from the scary narrative that inflation is about to pop a massive bond-bubble fuelled by quantitative easing and massive global debt increases? Should you go one further and actually put on negative bond exposure by shorting them? Not quite.
Firstly, the term bubble gets bandied about much too often. What it should refer to is a situation where a speculative instrument, usually driven by irrational exuberance, massively increases in price before imploding spectacularly. Not only is it a stretch to describe those who have bought bonds up until now as ‘exuberant’, the fact remains that it is difficult to lose large amounts of money investing in quality investment grade debt. If you buy a 10-year US treasury and wait 10 years, you will get your money back (with interest) unless the US Treasury and Central Bank collapse (at which point we’ll all have bigger problems to deal with than asset allocation). This isn’t to say you can’t lose some purchasing power if inflation exceeds coupon payments, or that currency exposures can’t go against you if you buy unhedged foreign bonds, but we’re not dealing with a bond bubble.
Secondly, bonds do fulfil a useful role in portfolios. The fact that they aren’t perfectly correlated with equities means they provide diversification protection. This correlation does fluctuate with time and does go through periods of being positive, but overall adding bonds to portfolios increases risk-adjusted returns. Bonds also add stability to portfolios. They are much less risky than equities, the same Bloomberg Barclays Global Aggregate had about a fifth the volatility of equities over the past five years, so bonds are useful when clients are uncomfortable accepting the full risk of equities.
And lastly, however distant it now seems, bonds are excellent at providing protection in the case of a deflationary shock which would likely decimate growth asset classes such as equities. One should never ignore the benefits of tail risk hedges.
So, whilst it’s good to admit that bonds aren’t going to drive portfolio returns from here and it’s a good idea for investors to reflect on the exact make-up of their bond exposure, bonds shouldn’t be completely ignored in portfolios. And as for shorting bonds, a word of warning. It’s been tried before, and traders attempting it with Japanese bonds have a name for how successful it’s been so far. They call it the widowmaker.
This article first appeared in the March edition of The Trade Press publication.