Why bonds are still a useful diversifier
Amid persistent inflation, soaring interest rates and geopolitical turmoil, both shares and bonds struggled in 2022. Yet the environment has shifted this year and we believe bonds still have an important role to play in multi-asset portfolios.
Bonds are essentially a form of lending where an investor loans money to either a company or a government for a set period of time, typically spanning several years. You’re not just giving it away when you hand over your hard-earned cash. In return, you receive a fixed rate of interest at regular intervals.
The majority of bonds are issued by governments, and those issued by developed countries are generally considered to be low risk. The reason is that governments are deemed less likely to default on their loan payments to bondholders.
In the UK, government bonds are known as gilts, while in the US they go by the name of Treasuries. So in a nutshell, bonds are a way for investors to loan money and receive regular interest payments, with the assurance that their initial investment will be fully repaid when the bond matures.
Why it pays to diversify
When investing your money, you have many options. These range from choosing a single company share to a wide-ranging set of assets like shares, property and bonds in the UK and across the world. People often choose multiple assets in order to reduce their risk.
One company share may fall in value but the likelihood of all assets falling at the same time has proven to be unlikely in the past. For example, your shares could fall but your other assets may hold steady or increase in value so protecting your overall investment value – spreading your risk means not putting all your eggs in one basket. Therfore, it’s important to ensure you have the right mix of asset classes in your portfolio. So what do bonds bring to a portfolio?
The value of bonds in your portfolio
Bonds play an important role in a well-diversified portfolio by helping to reduce sharp falls in the value of the portfolio. In the past, bonds have typically been a more steady investment with smaller rises and falls in value, when compared with shares for example. They offer a more stable income stream, especially during periods of unexpected shocks or uncertainty.
By investing a portion of your portfolio in bonds, investors can reduce the risk associated with more volatile shares. The appropriate mix of shares and bonds in a portfolio will be dictated by your financial objectives and your attitude to risk – these are areas you’ll discuss and agree with your financial adviser.
While corporate bonds (those issued by companies) can carry more risk than government bonds, they still tend to be safer than shares since they provide guaranteed interest payments. At Omnis, our bond investments are actively managed, which means our fund managers can look at different types of companies and governments and identify areas they believe have the highest return potential.
What happened to bonds in 2022?
Although we typically assume that bonds and share prices don’t move in the same direction, providing a diversification benefit, this is not always the case. For instance, in 2022 when interest rates were still rising, despite rapidly weakening economic growth expectations, bonds and share prices both fell at the same time.
The rapid reopening of the global economy after the pandemic lockdowns, followed by the invasion of Ukraine resulted in labour and energy shortages – two large supply shocks. Consequently, inflation went up and economic growth expectations started to fall – a bad environment for both bonds and shares.
While such a combination of rising interest rates and falling growth can be expected in most economic periods, it is typically short-lived because governments take action to try to reduce demand. However, if inflation is the result of a supply shock, rising interest rates are less effective at bringing inflation down and therefore interest rates have to rise higher and faster for longer than might normally be the case.
With the economic outlook appearing to be less pessimistic than many had previously thought this year, shares have performed relatively well so far in 2023.
However, bonds have continued to struggle as stickier inflation means interest rates are likely to have to remain higher for longer. Our view is that at some point in the next year, interest rates will begin to come down as inflation starts to fall. This means the usual diversification benefits of bonds should come back to the fore.
We believe bonds still have a useful role to play. While you may feel that with bonds and shares falling at the same time, multi-asset portfolios may no longer provide diversification, there is no need to panic – normal service should resume shortly.
In a usual business cycle, when central banks are raising interest rates to combat inflation caused by excessive demand, companies can expand their revenues. Typically, bonds struggle while share prices do well. Conversely, when interest rates begin coming down because there isn’t enough demand in the economy, bond prices do well while share prices may lag due to the lower demand. 2022 was unusual in that both economic growth was declining and interest rates were rising rapidly, leading to a reduction in the diversification benefits between shares and bonds. Remember that inflation in 2022 was driven by an inflation shock and not by excessive demand.
However, as the current economic situation improves, with inflation and interest rates falling and global supply chains improving, we expect bonds and shares to perform well and support multi-asset portfolios.
Corporate and government bonds have been underperforming despite an uncertain global economic outlook. Last year was particularly challenging for cautious investors (who have higher levels of bonds in their portfolios) unaccustomed to experiencing losses in bonds.
Fortunately, early indications this year suggest economic growth may not be as bad as feared and inflation is declining in many markets. This ultimately paves the way for central banks to begin cutting interest rates once again.
Bonds are looking a lot more attractive today than they did a year ago, with long-term expected returns improving considerably (figure 1). In the medium term, we are positive on bonds, particularly short-dated bonds (these are bonds that mature within one to five years). While slow economic growth means stock markets could struggle, we think bonds will come back to the fore, providing their usual diversification characteristics in multi-asset portfolios.
It’s also worth noting that bond and share prices can also rise at the same time, especially when economic growth strengthens and interest rates begin to fall. While we have not yet reached that stage, we expect a return to more normal conditions in the near future.
Figure 1: Long-term expected bond returns (%)
This figure shows the expected annual returns from bonds over the long-term (over 10-15 years). The blue bars show the expected returns as at the start of 2022 and the yellow bars show the expected returns as at the start of 2023 – the long-term outlook for bonds has improved significantly.
Approved by Omnis Investments on 22 June 2023.