Bonds have been out of favour for much of the last 10 years as quantitative easing saw bond yields grind closer and closer to 0% throughout the 2010s. However, the bond market has returned to the flourishing fruit tree it once was. And now everyone wants to pick some juicy apples.
Bonds (a vehicle to lend governments and companies money in return for fixed interest payments) have seen a resurgence alongside cash savings products. The two should not be conflated, however, despite the similar returns that some bonds and cash deposits appear to offer as interest rates have risen significantly over the past two years.
The beginning of 2022 was an important inflection point in the story of bonds, but it’s certainly not the only one. 2022 was the worst year for bonds in the UK for some 50 years, which saw many a traditional balanced portfolio suffer as the usual inverse relationship between equities and bonds was found wanting.
That now seems some time ago, however. Bonds are back – and in a good way.
Strategic allocation
Bonds are typically a bread-and-butter diversifier for multi-asset managers like us at PortfolioMetrix. We like to think of them as akin to fruit trees. With bonds it’s about what the tree creates each year - the fruit is the income in this metaphor. In contrast, we consider equities to be like timber forests, where the growth of the trees themselves is the most important factor.
Back to more typical investing terms, where the key for multi-asset is understanding the interplay and relationship of different asset classes. And, despite the lack of inverse correlation that took place last year, it’s important to acknowledge bonds and equities do usually tend to provide balance to one another.
Particularly in times of weak growth, sovereign bonds (for example UK Gilts, US Treasuries, Japanese government bonds and those of other major developed markets) are a useful defensive asset class because they pay out regardless of economic growth. And when growth collapses, for example during the COVID-19 pandemic, government bonds benefit from “flight to safety”, demand increases dramatically, which in some cases saw values increase by 20-30% during the pandemic sell-off.
These drastic shifts in markets allow multi-asset managers like us to rebalance portfolios, sell some of these bonds that have grown significantly in price and take advantage of cheaper equities that have had a drop in price.
On that note, it is important to remember that despite being known for a certain stability, particularly in the case of government bonds, the daily value of bonds does fluctuate. Their price can rise for several reasons, typically because of falling inflation, interest rates, greater demand or due to improvements in credit ratings. This can happen in reverse, of course. The 2022 fall in bonds was due to steep rises in inflation and interest rates.
Regardless, if you hold the bond until maturity, you’ll always get your money back, aside from very rare defaults. And even then, the bondholder’s claim on any remaining money exceeds that of the equity holder. The volatility always comes out in the wash if you hold on to the bond to redemption, which is one of their greatest strengths. This differs greatly from equities, which have no redemption date and no guarantee of a return of capital.
Plus, moving away from fruit trees, bonds are also quite like elastic bands (we like our metaphors). When they fall, they don’t fall as far and then they tend to bounce back quite quickly – generally faster than equities, which often have significant, longer-term slumps.
Using bonds in 2023 and beyond
One of the most important contexts in which to place bonds is that of longer-term interest rates. Growth and interest rates tend to move in concert. Fundamentally, interest rates are driven by economic, productivity and population growth.
Let’s take the yield curve in the UK, which is slightly inverted at the moment: cash rates are slightly higher than long-dated bond yields. This is important because it tells us the longer-term view of inflation and interest rates is that they’ll eventually be lower than their current levels.
Interestingly, if you buy gilts in an environment where yields are already high – and before rate cuts begin – you tend to see some capital appreciation. This is a big advantage compared to locking away money in cash deposits where lower rates just mean you earn less.
So in practical terms, if you invest in bonds before and as the rate cuts begin, you can make those capital gains. The bond market, as they say, is the ‘clever’ market – the one that’s looking forward 20-30 years on any given day. If investors want to take advantage of higher interest rates, which they are at the moment in late 2023, then it may be a good time to invest before the rate cuts begin.
That is why we’ve launched our PortfolioMetrix Short-Term Gilt Model, which is an application of all this knowledge. We are buying UK government bonds – those with less than 5 years to maturity with a bias towards those maturing within 2 years – with the intention of seeking cash-like returns with little risk. Importantly, the capital appreciation on the bond is not taxed for individuals when held outside of a fund structure. When this model is held in a General Investment Account, for example, it offers greater tax efficiency over rival products like cash accounts.
We think this model is tactically astute in the current economic climate because of the situation we find ourselves in with interest rates. Rates have been low for a number of years but have risen to more normalised levels. British government bonds that were issued when interest rates were low, the taxable portion of the bond, the coupons, were close to 0%. But as we’ve moved to a higher rate environment, those bond prices have gone down. They are trading significantly below par and so, as they get closer to maturity over time, their price will rise.
This means there are a whole host of UK government bonds with very low coupons but have a strong forecast for recovery and growth, which is great for this strategy.
This creates an opportunity for a savings product that is highly tax efficient. Ripe apples are available from the fruit tree once again – and investors have the opportunity to enjoy them once more.
