Investments  

The role of government bonds in an income portfolio

This article is part of
Guide to managing bonds in an income portfolio

The role of government bonds in an income portfolio
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One of the great questions of market history will always be: what would have happened post-financial crisis if central banks had not deployed quantitative easing?

A hint to the answer to that came with October’s very sharp bout of volatility in government bond markets, which peaked with the yield on some US government debt reaching a 17-year high, as governments seeking to borrow money to fund spending plans find they are competing for capital at higher interest rates than has been the case for a decade, and without having the central banks in the market as major buyers of the debt. 

Collapsing prices of course mean higher yields, and therefore the asset class may be more attractive to investors with income as a focus. 

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On the other hand, government bonds are typically placed into portfolios with a remit to dampen the volatility associated with equities and equity-like investments

So if government bonds are going to contribute to volatility, what role can they play in a fixed income portfolio? 

Alberto Matellán, chief economist at MAPFRE, says the change investors are trying to digest right now is not simply that we are transitioning away from a decade where rates were low, but, in reality, a “40-year period where inflation was mostly coming down, and bond yields were coming down. In the past two years we have had a situation where government bonds have gone back to the level they were 15 years ago, it’s a huge transformation.”

Higher bond yields of course mean lower bond prices, and in more normal market conditions a decline in the expected level of future economic growth would usually be expected to cause investors to rush for the safe haven of government bonds, pushing the yields down and the prices up.

That introduces the potential for capital appreciation from bond holdings, but would also reduce the income available to those who have that priority.

A PIMCO representative says: “When rates were very low, investors lost some of the diversification benefits that people look for in fixed income. We saw this happen in 2022, with some painful losses in both the bond market as well as equity markets.

"Where we are today and looking forward, the good news is that with government bond yields much higher you now get that diversification benefit and the opportunity for an attractive total return."

Matellán says one of the reasons for the profound market sell-off in October was the market revising its expectations about the outlook for inflation and economic growth. 

Due to the market had started to expect an economic deterioration, bond prices had begun to reflect market expectations that rates would soon be cut as inflation fell. 

Lower rates would mean the coupons available on future government bonds would be lower than those on current bonds, offering the potential for capital gains, while if inflation does fall, it increases the purchasing power of the yields earned on bonds, potentially making them more attractive as an income investment.