Bonds have to a large extent reverted to their historic role within portfolios as rising yields mean they can provide an income, and potentially diversification from equities if economic growth slows.
But the challenge from a portfolio construction point of view may be that while bonds are currently on a path that the textbooks imply they ought to be, the journey for investors in the asset class over the past two or so years has been acutely volatile, and heightened volatility from the fixed income allocation is the opposite of what many multi-asset investors anticipate from their bond portfolio.
Fahad Hassan, chief investment officer at Albermarle Street Partners, says: “Last year was a test of nerves for income investors as they discovered the downside of fixed income duration.
The yields on investment-grade now are around 5 per cent, and when they are at that level I’m sure one needs to go anywhere else if yield is the priority.>---Michael Walsh, T Rowe Price
"As yields ratcheted higher, average duration [six to eight years] in benchmark allocations became a source of considerable volatility and drawdown.
"Investors who failed to shift to shorter duration or alternative allocations saw severe losses.”
But while it was tough to make money from a passive exposure to equities, Morningstar’s director of manager research Jonathan Miller notes that actively managed bond funds were marginally more likely to outperform relative to the index in 2022.
He attributes this to the fact that bond managers who simply switched to shorter-duration assets would likely have outperformed as the index is quite long-duration in nature, and no further stock selection skill would necessarily have been needed.
Hassan says: “Income portfolios should consider 2023 as a more favourable environment for duration as global bond yields seem close to peaking.
"While shorter duration fixed income allocation still stands to benefit in a falling yield environment, they are likely to see smaller gains than the benchmark.
"It is therefore important for asset allocators to own benchmark duration exposures in government and investment-grade allocations.
"Inflation-linked bonds faced severe drawdowns in 2022 as rising yields more than offset the benefits of rising inflation.”
He continues: “As we enter 2023, inflation-linked debt faces a challenging backdrop as investors face the risk of a sharper fall in inflation, which could undermine the attractiveness of the asset.
"UK inflation-linked debt faces the added disadvantage of currency-driven swings. This adds additional volatility to an already challenging backdrop for this asset.
"In terms of riskier parts of the fixed income market – (high-yield debt, emerging market hard currency, emerging market local, financial subordinated debt and collateralised loans), there are some attractive yields on offer, and a diversified risk-controlled allocation to high-yield and EM dollar debt can be justified based on the implied default rates and the yields being offered by the asset class.”
Changing times
For Eugene Philalithis, head of multi-asset management in Europe for Fidelity, the fact that bond yields have risen sufficiently that the asset class could now be expected to perform differently to bonds means that “it is possible to construct portfolio with a decent income yield using a mix of asset classes that are not excessively risky. That has not been possible for quite some time.
