Wayne Nutland, head of Managed Index Solutions, Premier Miton Investors considers potential future scenarios and strategies.
Government bonds have served multi-asset portfolios well during 2020. Despite predictions that government bond yields could fall no further, the market response to the coronavirus pandemic has seen bond yields move even lower. The statement that valuations are not a good guide to near term returns is often used in reference to equity markets, but 2020 has proved again that in bond markets the same is also true – yield to maturity is not a good guide to near term returns.
When considering potential future scenarios it’s important to consider why bond yields fell in 2020. Although investor preference for safe haven assets and increased quantitative easing have been supportive of the move lower in bond yields, likely suppressing term premia, the most important driver of bond yields is the path of forward interest rates. Lower yields reflect markets moving to price in lower interest rates and the likelihood that interest rates will stay even lower for even longer.
Consequently bond yields are unlikely to move materially higher until markets can begin to price in interest rates increasing sooner than previously expected or increasing assessments of long term interest rates (or both). Although government bond yields have risen somewhat in recent weeks, the prospects for significantly higher moves seem distant, particularly given the Fed’s shift to average inflation targeting and the apparent reduced likelihood of a ‘blue wave’ fiscal spree following the US elections.
However, even if bond yields are unlikely to move materially higher in the near term, starting yields are lower and more importantly there is less scope for capital appreciation from falling yields. It’s notable that this year falls in government bond yields were not uniform across the major bond markets, with US yields falling much further than yields in the UK, Germany or Japan, the latter two in particular having had much less scope to fall.
Although prospective long-term returns from government bonds are likely lower now than was the case in recent years, the ability of bonds to offer some protection from equity drawdowns remains, at least in the case of risk-off, or deflationary episodes.
Consequently it makes sense to reduce allocations to core government bond markets, but to retain some exposure, and arguably to be more granular in the exposures taken, for example retaining some exposure in areas where yields are relatively higher and where curves are relatively steeper. Take the US for example, when currency hedged back to sterling, yields at the short end of the curve are very low, or even negative. But smaller positions (to reflect higher duration) at the intermediate and longer ends still have scope to provide some portfolio protection, whilst the US rates curve has steepened this year, unlike curves in the UK, Germany or Japan.
If government bonds can continue to play a useful diversification role, but with lower prospective returns, it makes sense to diversify away from core bond markets into other areas with potentially more attractive returns. Unfortunately most of these require somewhat higher levels of risk to be taken.
For portfolios able to take additional credit risk, credit spreads remain higher than prior to the crisis making corporate bonds relatively more attractive than government bonds, even if overall yields are historically low. Although the economic risks associated with the crisis are far from healing, defaults have so far been more benign than was predicted, whilst the prospects for central bank support may reduce the risk of sharp sell-offs.
Returning to government bonds, US government inflation linked bonds may offer better returns than conventional bonds going forward, albeit with an increased correlation to equity markets. Breakeven levels remain below the Fed’s target for inflation, and whilst inflationary pressures appear benign, low nominal bond yields mean that real yields at least have the scope to move lower (bringing price increases) if breakeven rates increase.
Elsewhere, Chinese government bonds offer an interesting alternative to core bond allocations, albeit currency risk needs to be managed in a portfolio context. Historically not considered part of most investors’ opportunity set, Chinese bond markets have become more accessible to global investors and the large index providers have begun to include Chinese bonds in their flagship bond indices. This, combined with the increasing importance of China in global capital markets means that investors should consider Chinese allocations as stand-alone positions in both equity and bonds, as opposed to being part of broad emerging market allocations.
Chinese bonds have demonstrated low levels of correlation with other major bond markets, reflecting the importance of local policy and economic factors. Furthermore, Chinese bonds have exhibited lower levels of volatility than many other emerging market bonds and there is a case for regarding China as a ‘quasi developed’ market.
Unlike the other major bond markets, Chinese yields have actually increased this year, as the Chinese authorities haven’t needed to resort to the aggressive monetary policy actions which have been undertaken by the major developed market central banks. This, and the relatively successful recovery from the crisis means that whilst Chinese bond yields may not decline in the near future, they at least offer attractive yields on an unhedged basis, with scope for yields to fall in the future. Furthermore unhedged positions may benefit from continued appreciation in the Renminbi over the longer-term.
Overall, government bonds can continue to offer balanced portfolios scope for portfolio protection. However with yields lower, it makes sense to be selective in exposures to core bond markets and to diversify into other areas, if risk tolerance allows.
