For most of the decade after the financial crisis, advisers were presented with a dilemma.
Until that point the role of government and other lower risk bonds in client portfolios was to balance the volatility of equities, while also providing an income.
That was based on the notion that bond prices move inversely with equity prices, as when times are good investors have the confidence to buy equities and worry less about downside protection, so sell their bonds to buy equities.
This inverse correlation is the centrepiece of the 60/40 portfolio construction model, which underpinned many client’s 'balanced' portfolios.
However, following government intervention during the financial crisis, and in current times as interest rates and inflation have risen, bonds and equities have been falling in tandem, leaving investors in a quandary.
During the financial crisis, low rates contributed to most equity markets rising consistently, while quantitative easing involved central banks buying bonds in large quantities, pushing prices up and yields down.
This meant the traditional inverse correlation broke down. Now with rates rising and central banks reversing QE, bonds and equities are falling at the same time.
The extent of the pain being felt by investors can be seen in the 10 per cent decline in the value of the UK Gilt since the start of the year.
Matthew Yeats, head of alternatives and quantitative research at 7IM, says: “The income element of the reason to own bonds changed years ago, and while bond yields have risen, the income is still very low now. By some measure bonds are having their worst falls since the 1970s, but the income is still low because the yields started from such a low level.”
Bryn Jones, fixed income director at Rathbone Unit Trust Management, says that while bond prices have fallen sharply this year, “we are at the point where the yields on government bonds are now in positive territory, at least nominally, and that means [the old inverse correlation has returned and] you can once again get an income for taking out the insurance policy on your equity portfolio [because government bond prices will rise if equities fall], so while there has been a correction in the bond market, I don’t think its a case of bonds being dead”.
He adds that he began to buy bonds with a shorter date to maturity in October 2021, in expectation that rates would rise, which proved to be the right call, but also had exposure to more economically sensitive bonds, which have sold-off.
Jones says one of the key reasons why bond prices have fallen so sharply this year is that usually when interest rates are rising, the economic outlook is positive, so the economically sensitive sectors do well, but with rates rising and the economic outlook darkening, all parts of the fixed income market have suffered.
