Bonds, Huh, Yeah! What Are They Good For?

Unlike the next line in the song …”absolutely nothin’…”, we do think bonds are “good for somethin’…”(with apologies to Edwin Starr and his song “War”).

With yields low and fixed income return prospects paltry, the question we are hearing more and more from advisors is about the purpose or role that bonds still play (if any) in multi-asset portfolios. Traditionally, bonds serve two purposes in a portfolio:

1. For capital preservation and a buffer to equity risk, generally with government bond exposures, and
2. As a source of income and/or return enhancement, generally via credit, securitized instruments and other spread products.

We will focus on the first role in this article and whether bonds can still serve this purpose.

When Yields Rise

When yields are rising it means low and even negative returns for many government bond markets. However, we believe that investors will not see materially higher yields from here, given the measures introduced by central banks during the coronavirus pandemic, which could prove more lasting. These include lower for longer interest rates, continued quantitative easing programs, and potential for more flexible inflation targeting regimes. So, the return environment for bonds will be challenging, but by no means disastrous.

Why Yields Rise

If yields on government bonds increase for the right reasons – better growth, inflation normalization, a better economic outlook – that may be a headwind for some parts of the bond market, but it can still be a great environment for your portfolio. Other parts of the portfolio may make up for return headwinds for developed market government bonds. For example, a 60/40 and even an 80/20 mix of stocks and bonds can still perform quite well, as we have seen in the recent back-up in yields:

Added Cushion

Rising government bond yields do have an upside because they will naturally build back some of the protection inherent in sovereign bonds. To be clear, we don’t expect a large move up in yields; but for illustrative purposes, if yields rise to the levels of the following table, that would be a headwind to returns but it would also help increase the available “ammunition” for the next risk-off event and assumed fall in yields.

What Is the Role of Government Bonds?

Our view is government bonds still play an important role for capital preservation and as a buffer to equity risk. However, it must be acknowledged the ‘cost’ to hold government bonds has gone up, given the lower expected returns and less efficient (but not zero) diversification benefits going forward. Therefore, it is important to diversify portfolios and complement government bond exposure with other tools.

Be Discerning and Active

In our view, investors need to be dynamic and discerning with their government bond exposure, given the environment of historically low government bond yields. We are currently underweight government bonds and have a shorter duration given our view of somewhat higher yields going forward, but our allocation is not zero! We are focused on government bond markets that have higher potential for capital appreciation in risk-off events. For example, in the chart below, markets like Australia, Canada and the U.S. have higher starting yields versus Japan and Europe, potentially allowing for greater capital appreciation in weaker economic environments.

Secondly, other tools that can help offset equity risk and provide diversification should be considered to complement, but not necessarily replace, government bonds. Other defensive fixed income sectors, certain currency pairs, precious metals, and, for those that can access them, alternative investments are examples of tools that can be used to complement the traditional role government bonds play in a portfolio.

Finally, given compressed yields, the benefit of being active in bond positioning within sectors, quality, yield curve, duration, foreign exchange, geography, and single issuer names are all important to help optimize return prospects with the hedging characteristics fixed income is meant to provide.

Bonds in general, and government bonds specifically, are still a key building block for a well-diversified multi-asset portfolio. It is, however, important not to be complacent about how to manage your bond exposures.