Should rising bond yields prompt a re-examination of fixed income assets and their role in portfolios?
It has been some time since conventional sovereign bond markets have held much appeal for investors. Yields have been low, while rising inflation and interest rates created a difficult backdrop for the sector. Not holding sovereign bonds has been positive for investor portfolios, particularly over the past six months, but we believe it may be time to start re-examining that view.
The rise in yields in the first quarter of 2022 has been significant. The US 10-year treasury yield has touched 3% in recent days[i], its highest level since early 2019. This is above the Federal Reserve’s current projections, but also above the generally accepted neutral rate of around 2.5%[ii]. Real yields, after expected inflation, are also back in positive territory. Yields may not be high compared with longer-term history, but some of the key characteristics of fixed income diversification, risk mitigation – have been restored, alongside reasonable return prospects.
As such, we have started to see some merit in adding duration in conventional sovereign bonds into portfolios. In our asset allocation models, we closed out of our inflation-linked bond positions earlier in the year, and have been in a holding pattern in tactical cash since, while yields remained low. Since then, we have seen a significant sell off, pushing yields to levels that may offer an attractive re-entry point.
Sovereign bonds within portfolios
When thinking about the allocation to sovereign bonds, it is important to consider their role in the broader portfolio. In higher risk portfolios, for example, government bonds can play an important role in mitigating equity risk and so we generally favour taking a little more duration to increase the diversification benefits.
In the lower-risk models, fixed income is not necessarily there simply to insure against equity exposure; it needs to have return-seeking credentials as well. With that in mind, our allocation is partly assigned to sovereign bonds with a lower duration. These have a more attractive yield than cash, while also offering more modest mitigation against risk-off periods. The remainder is guided towards short-dated credit, where the coupons are still reasonably high and where there is less interest rate sensitivity.
All other elements being equal, we prefer US treasuries hedged back to sterling over UK government bonds. There has been a sharper rise in yields for US government bonds than for many other developed market bonds. This gives yields greater scope to fall (and prices to rise) and are therefore likely to provide better insurance if the global economy starts to weaken and investors hunt for a ‘safe haven’ or there is some other risk-off trigger. This is the thinking behind our tentative move back into conventional sovereign bonds for appropriate mandates.
Risks and portfolio balance
We are still a long way from a typical 60/40 portfolio but believe that balancing equity exposure is likely to become more important in the short term and current yields appear to provide a reasonable return in the meantime.
Equities will still likely be the core long-term return driver for portfolios, but there are a number of headwinds: the withdrawal of fiscal and monetary stimulus, plus inflationary pressures. This could make it difficult for broad markets to make progress. At the same time, recession risks are starting to be discussed. This is still not our base case, but it is a risk that needs to be addressed and means that careful stock selection within equity exposure is going to be especially important.
Re-evaluating fixed income
Of course, yields could rise further. We expect inflation to drop off in the second half of the year but it is likely to remain at higher levels. The reintroduction of government bonds is based on the balance of probabilities, rather than a high conviction that yields will fall significantly from here. Any further sell-off would probably make the asset class look more attractive. We may be seeing the slow revival of fixed income as a broadly viable asset class and it is certainly an area to watch.
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.
The value of an investment, and the income from it, may go down as well as up and you may get back less than you originally invested. Historical or current yields should not be considered reliable indicators of future performance.
Bonds issued by major governments and companies will be more stable than those issued by emerging markets or smaller corporate issuers; in the event of an issuer experiencing financial difficulty, there may be a risk to some or all of the capital invested.
[i] Marketwatch.com, U.S. 10 Year Treasury Note [accessed 5 May 2022]
[ii] Davidson, Paul, ‘Inflation is at a 40-year high. The Fed announced these aggressive moves to fight it’, USA Today Money [accessed 5 May 2022]
This article was previously published on Smith & Williamson prior to the launch of Evelyn Partners.