Staying patient in bond markets

Recent troubles

The disappointment investors have had with bond funds in recent years is undeniable. Looking at the three year returns of some of the main UK bond sectors to the end of May 2024 shows the IA UK Gilts sector down -23.5%, the IA £ Corporate Bond sector down -8.8%, the IA £ Strategic Bond sector down -3.4%, and the IA £ High Yield sector slightly up, +4.5%. All these markets have trailed the ‘risk-free’ IA Standard Money Market sector return of +8.3% over the same period.

The cause of the damage

Before we consider what the future returns of bonds could be, it’s worth considering why returns have been so poor over recent years. And it's not as simple as blaming the Liz Truss mini-budget of September 2022, as some might think.

In fact, the most relevant factor is that three years ago government bonds were very expensive, as bond prices had been driven up by a 13-year period of ultra-low interest rates and central bank government bond buying (quantitative easing) that had distorted the risk / return potential of bonds. This distortion occurred as these policies dragged down the future return potential of bonds whilst increasing the risk of losses from a reversal of the policies.

And reverse these policies did as central banks tried to combat high and sticky inflation, spurred by Covid-era government spending and supply chain bottlenecks, further accelerated by Russia's invasion of Ukraine and the war’s impact on commodity prices. Given this spiralling inflation and rising interest rates, bonds naturally came under pressure.

Over the same period corporate bonds managed to outperform their government equivalents as they are less vulnerable to rising interest rates given their typically shorter maturity profiles. Additionally, despite higher financing costs, corporates have remained remarkably resilient through the period, and the market’s perception of corporate default risk has, in fact, fallen.

Prospects from here

Thankfully, the inflation issues appear to be mostly under control now. And we are left with UK government bonds paying out a much higher yield (c.4.5%) than the c.1.5% to 2% that investors had become accustomed to in the recent past.

As well as higher starting yields, movements in the price of bonds are also more tilted in investors’ favour now than three years ago. With interest rates high, and economies vulnerable to the associated economic cooling effects of these higher rates, central banks may need to start cutting rates to encourage economic growth, which, in turn, increases the value of the existing bond stock and thus the returns of bond investors.

What's the risk to all this? Well, it remains inflation. So far central banks, other than the ECB, have shown little appetite for rate cuts until inflation is back to their 2% targets, and with US inflation remaining relatively sticky above 2%, meaningful rate cuts are not expected anytime soon.

Corporate bonds in turn are paying nice yields compared to recent history, above 5% for high-grade companies, and they too should benefit from any falls in interest rates. That said, the trade-off for this extra yield, the additional credit risk investors are taking beyond an equivalent government bond, does look expensive at current valuations.

Implications for our portfolios

Within some of our portfolios (risk profiles 1-4) we reduced our high yield exposure early in 2024, after having a relatively high allocation throughout 2023. This followed a number of years where it has been the strongest performing area within fixed income markets given its lower interest rate and higher credit risk profile. Essentially, at this point, we felt valuations had become somewhat tight in the market and that high yield no longer offered the relative value it once did versus other areas of the fixed income universe, particularly if developed market economies continue to struggle under higher interest rates.

Meanwhile, whilst not enamoured by valuations within investment grade corporate bonds, we do continue to prefer them for the resilience they typically offer in economic downturns, alongside their higher exposure to interest rate risk at a time when interest rates are likely at the highs of their cycle. We do continue to hold high yield within these portfolios and short of a large move in valuations, we are unlikely to make any further changes to the allocation in the coming quarters.

For higher risk portfolios that carry a narrower selection of fixed income (risk profiles 5 and 6) we have left the allocation to high yield unchanged as we feel its overall yield retains the ability to provide an ‘equity-like’ return but with lower volatility.

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