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Navigating the bond market

one year ago

Niall McDonnell, Senior Investment Manager

Niall McDonnell,
Senior Investment Manager, Architas

A tough year for bonds

2022 is turning out to be a tough year for investors. Inflation has soared to levels not seen for 40 years in many countries, fuelled by ongoing supply chain disruptions, pandemic stimulus measures and exacerbated by jumps in commodity prices following Russia’s invasion of Ukraine. This has prompted central banks to start raising interest rates. Higher inflation has hit consumer spending power and this, coupled with Covid related shutdowns in China, has put a brake on global growth. Meanwhile, investors have been impacted by falls in both equity markets and bond markets.

And although bonds are normally a safe haven when stocks are falling, they have also felt large losses this year. This is because global bond markets are experiencing the deepest downturn in decades. As investors brace themselves for a toxic mix of rapid interest rate rises from central banks battling inflation and recession risks. However, the factors underlying the bond market rout aren't unusual. Rather, it is the speed and extent of the losses and the accompanying jump in yields that are unique to the circumstances of the post-pandemic economic recovery.

Why hasn’t diversification worked this year?

Inflation at higher levels is driving central banks to hike interest rates, causing bond prices to fall as their yields adjust to new interest rate expectations. And investors are not used to experiencing such dramatic losses in their bond portfolios, particularly when equity markets are also plunging. One of the key reasons why bond prices have fallen so sharply this year is that usually when interest rates are rising, the economic outlook is positive, so the economically sensitive sectors do well, but with rates rising and the economic outlook darkening, all parts of the fixed income market have suffered. But it’s not just inflation skewing the relationship. Bond and equity markets started 2022 at elevated valuations compared to long-term averages.

Are we at a turning point?

We may be at a turning point. The near-zero interest rates from central banks weren’t sustainable. In the short term, inflation is putting serious pressure on bond prices. But over the longer term, this should be good news for investors looking to buy into bonds. And rising yields will eventually benefit investors with bonds in their portfolio. That’s because the total return you receive from a bond fund is a combination of the price change and income from the bonds, and the income is rising. The recent sell-off in government bonds actually means they can revert to their pre-global financial crisis status as diversifiers if a recession happens. That should improve the outlook for stocks and bonds over the long term once we get through it.

Hope on the horizon

Also, there could be a glimmer of hope on the horizon for bond investors. Government bond markets have begun to claw back part of this year’s heavy losses as attention shifts away from sky-high inflation to worries about a potential recession. So investors may pay a price if they give up on bonds now. The expected return on bonds is low and they aren’t providing all of the benefits of diversification that they have in the past. But in time, they should continue to deliver in a crisis, when you get an extreme flight to safety.

Investing for the long term

Bonds can still serve as a safe haven asset in the long term, even giving investors the opportunity to buy the current dip. Unless you’re confident about your ability to time the market, it may be best to stick with a long-term plan. But that involves accepting some losses when stocks or bonds decline in price. But if you look at the relationship between equities and bonds, investors have benefited from a 20-year period in which when stocks fell, bonds were likely to rise. In just under 30% of the time, they fell together, the rest of the time, they moved in opposite directions. So just because the link is broken now, it doesn't mean it will be over the long term. 

Architas view

Conclusion and view

Right now, it seems like there is nowhere to hide when it comes to finding positive investment returns from an asset class perspective, with stocks and bonds falling in lockstep at a pace unseen in decades. And while we expect the trend to continue in the short term, and we are already seeing some change. But over the longer term, we believe the situation will stabilise with inflation moderating. As a result, the stock-bond relationship should gradually return to negative.

Though equities and bonds have both fallen this year, government bonds have fallen much farther, and would be expected to rise in the event of an economic downturn, while equities would fall further. A positive for the future is that rising bond yields now mean that you will receive more income from your bond funds in a few years.

We believe investors should be wary of exiting bonds, even though the asset class has been caught up in the sell-off that has dominated the start of 2022. From our perspective, given the number of hikes already priced in by the markets, we think bonds could likely provide a safe haven if growth turned negative.

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