Asset allocation update: bonds offer opportunities once more

This article explains why we believe the time has come to reconsider bonds as part of a diversified portfolio.

Asset Allocation Bonds Nov 22
Ben Seager-Scott
Published: 01 Dec 2022 Updated: 31 Jan 2023
Savings and investments IFAs

2022 has been a tough year for fixed income. In most cases, it has not provided an income, diversification or defended capital. However, with yields now at decade highs and the bad news on interest rates largely reflected in prices, fixed income may now be able to fulfil these roles in a portfolio once again.

As part of our most recent update to asset allocation guidance, we have upgraded our view on bonds. At the start of the year, we held the view that investors should generally avoid conventional government bonds – yields were near zero and they offered little reward for considerable risk, given mounting inflation. The sell-off since then has been painful for investors in this asset class, many of whom were holding them as a source of diversification and ballast in their portfolios.

However, yields have risen a long way as financial markets have adjusted to higher interest rates, meaning we started to become more constructive on bonds from around the middle of the year. This began with updating our guidance to start dipping our toes back into conventional government bonds for appropriate mandates. Now we think the investment environment is right to guide towards a further increase in the fixed income market, with yields on most mainstream bonds now above the forward-looking inflation measures.

Risk-based strategies

We believe the role fixed income plays in a portfolio varies depending on where a given investment strategy sits along the risk spectrum and our asset allocation guidance reflects this. In the higher-risk models, we have introduced more conventional government bonds, with around the same interest-rate sensitivity as the benchmark. Investors can collect an income while also providing some protection should there be further falls in equity markets.

For lower-risk models, fixed income also needs to contribute to investment returns. Here, our guidance has focused on shorter-duration government bonds and investment-grade corporate bonds. The latter now have an attractive yield with less interest-rate risk. We favour implementing this higher fixed income exposure primarily by making a marginal reduction in equities (reducing market risk) and putting some cash to work.

There has been a short-term bounce in markets since mid-October, with UK and European markets benefiting most. We saw this as an opportune moment to pare back some equity exposure.

Inflation

This rotation doesn’t reflect a significant shift in our view on inflation. We still believe inflation will remain high, but may come off its peak. There are still profound inflationary pressures including: higher wage demands, deglobalisation and the shift from efficient to more resilient supply chains. As supply chains move closer to home, developed markets are no longer importing disinflation from emerging markets.

However, just as the strength of inflation has surprised policymakers and investors in 2022, other scenarios are plausible. For example, tight monetary policy  –high interest rates – could choke off some of the demand in the economy just as supply chain problems start to resolve. This would create deflationary pressures.

The final point worth noting is that the inflation shock has driven an increasingly positive correlation between equities and bonds. That shock now appears to be moderating. With concern shifting towards the strength (or otherwise) of economic growth, we would expect bonds to return to their more typical negative correlation. This is another argument for selectively adding to bonds.  

It is too soon to suggest that we are entering a new era for financial markets. However, shifting valuations, particularly in bond markets, have changed the risk/reward dynamics for investors. It is this shift that we are reflecting in our asset allocation guidance.

Important information

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.

Past performance is not a guide to 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.