It has been a torrid start to 2022 for bonds. Spiralling inflation has transformed the long-moribund interest rate environment and yields have risen substantially in most major markets. Not only are most bond investors nursing losses, but these losses have been registered at a time of equity market weakness. Bonds have seemingly lost their diversifying properties, produced poor returns and face into a prevailing market narrative that paints an unremittingly bleak outlook for their prospects. Given this, is it fair to question why anyone would hold bonds in this environment? No, it is not.
The unremitting negativity around bond investing reflects several major behavioural failings we face as investors – we greatly overweight the recent past, are overconfident in our ability to predict the future and struggle to accept the behavioural realities of diversification.
Rather than obsess over short-term performance and negative sentiment, it is far more important to think about the features of bond investing, the role they play in a portfolio and what recent market activity means:
– Rising yields should mean higher future returns:
The best predictor of bond returns is their starting yield. The significant rise in yields mean that future performance prospects are now brighter than they were. I would much prefer a 3% yield from a ten-year treasury (nearly) than the close to 0.5% it reached in 2020. It is incredibly common for investors’ return expectations to perversely increase as valuations become more expensive (it happens in equity markets consistently) but it is more puzzling in bonds where the interest and principal payments are contractual.*
– The chances of losing money in bonds in any given year have reduced:
Aside from those with negative yields, at the start of each year our expected return from a bond investment is positive – we will receive our coupon and roll down the yield curve (for the sake of simplicity let’s assume the curve is not inverted and there is no credit risk). The higher the yield and steeper the curve, the more yields need to rise for bonds to lose money. The considerable increase in yields means that our chances of losing money in bonds over the course of a year have reduced significantly. Higher yields give us greater protection from the threat of rising interest rates. This was detailed in this typically excellent Verdad post.
– The market has the same information as us:
The concerns about the prospects for bonds – central bank rate hikes, rising inflation etc… – are generally expressed as if the market is blithely unaware of these risks. It isn’t. The behaviour of bond markets in 2022 reflect the attempt of market participants to accurately price them. What is it we know about inflation and rates that the market does not?
– Bonds represent a diverse range of security types:
Although I am guilty of discussing bonds in incredibly generic terms here, we should not forget the diverse range of securities that are encompassed by this broad definition. The features and sensitivities of floating rate notes are distinct from a treasury bond (real or nominal) as they are distinct from a CCC high yield credit. It is important to understand both the similarities and distinct features of the various areas of the market and the specific role they might play in a portfolio.
– High quality bonds are excellent diversifiers
High quality bonds are an excellent portfolio diversifier when held alongside risky assets. Despite recent returns they are likely to remain one of the most effective protections against equity market risk. No asset class works against all backdrops and in a stagflationary environment where inflation is rising and equities are weak, nominal bonds may fare poorly – but that is just a single specific scenario. In a more typical equity sell-off or economic slowdown, it is reasonable to expect higher quality bonds (particularly sovereigns) to be an effective component in a portfolio. **
– Rebranding government bonds
Government bonds have something of an image problem – the common complaint is that yields are so low that there is no point in holding them compared to other asset classes (this is less true than it was a year ago). But rather than thinking about low returns, it pays to reframe their role.
High quality government bonds are typically (though not always) lowly correlated with equities, and they often make profits when equity markets suffer severe declines. This sounds like a reasonably effective portfolio diversifier and unlike a tail risk hedge there is no burn cost, in fact we get paid somewhere close to 3% (US ten year) for owning it.
From a portfolio perspective, it is critical not to focus solely on an asset’s expected return but how it behaves relative to other positions in a portfolio. The value of something that can protect value or even make money when equities are losing heavily is not simply about lower drawdowns and volatility. It is about the ability to rebalance and reallocate from your defensive asset into much more attractively valued risky assets. The compound impact of this through time can be profound.
Of course, it is worth restating that nominal government bonds are not always a good diversifier against equities, but they often are and being paid to own those characteristics can be a compelling option from a portfolio perspective.
– The future is unpredictable and we are overconfident
Given the inflationary backdrop and recent losses, it is not surprising that sentiment around bonds seems uniformly negative. In the current environment it is incredibly easy to take strident views about the direction of yields from here (higher) and claim that owning bonds is nothing more than a wilful destruction of value. We should ignore such perspectives.
A call to give up on bonds is nothing more than an aggressive market / macro-economic forecast and we all know how successful investors are at making those. Prudent diversification is about owning assets and securities that will deliver in different market environments because the future is unknowable.
At any given moment it always feels like we are on a single inexorable path based on recent information, but that is never the case. There is always a range of potential outcomes.
Let’s map out a future scenario – inflationary pressures remain and central banks hike rates aggressively to subdue it. The rising cost of money leads to significant pressure on consumer demand and results in a recession. This is a highly stylised and simplified example but does not have a zero probability and it is an environment where exposure to high quality bonds might be valuable.
There is another scenario where inflation runs further away from central banks and bond yields must rise substantially to reflect a new reality even as equities decline. The point is we cannot know with any confidence how the economic picture will play out, nor how asset class relationships may alter.
We should make investment decisions based as much on what we don’t know, as what we think we do.
Current concerns about bonds are simply a reflection of our behavioural struggles with diversification. Diversification means that at any given point in time elements of our portfolio won’t be working, which is dissonant with our inescapable desire for everything to be performing in unison.***
If all holdings in our portfolio are successful at the same time, we should prepare ourselves for the time when they all struggle at the same time.
Highly concentrated positioning or the abandonment of certain asset classes is little more than a reflection of dramatic overconfidence. Either we believe in maintaining diversification, or we believe that we can predict the future.
* It is important to remember the distinction between owning an individual bond – with set characteristics and, typically, a fixed maturity – and a bond fund which usually has an evolving set of fixed income exposures.
** Bonds are by no means a requirement for all types of investors, but for an investor whose risk appetite would usually involve holding fixed income securities abandoning them would be nonsensical.
*** Diversification applies across asset classes and strategies, not bonds alone.