It has been a torrid few years for bond investors, with rapidly rising interest rates causing havoc across the fixed-income landscape.
Looking at 51 Investment Association sectors (we excluded Unclassified, Specialist, Volatility Managed, Targeted Absolute Return, Property Other and Not Yet Assigned as these peer groups are too wide-ranging, making sector returns relatively meaningless), bonds dominate the worst-performing peer groups over the past five years.
IA UK Index Linked Gilts has performed the worst, down 35.6%, followed by the IA UK Gilts sector (-19.6%). In total, eight of the bottom 10 peer groups focus on bonds, with the best-performing fixed-income peer groups (high-yield specialists) sitting around mid-table.
Greg Peters, co-chief investment officer of fixed income at PGIM, said the bond market “lost its way” in the post-Covid era, with people focusing too much on capital gains and not enough on carry and income.
With bonds in some cases offering no or even negative yields, the picture for fixed income at the start of the decade was bleak.
“Nobody liked owning a bond yielding that low,” he said. This meant the asset class became about capital appreciation – which is not something it has ever been designed to accommodate.
Post-Covid this rapidly readjusted, with interest rates rising from next-to-nothing to around 4% (or as high as 5% in some places, such as the UK).
This has led to the recent poor performance, with yields spiking higher and therefore their prices plummeting. Now bond investors have to contrast two differing thoughts.
On the one hand, the current environment remains very difficult to navigate; governments are in huge deficits that are getting worse, while the amount of corporate debt continues to increase as the AI build-out is increasingly financed by loans rather than cash.
However, Peters noted that yields are attractive and can hide a multitude of sins for bond investors, who can afford to keep claiming reasonable coupons with no need to sell.
“I feel really good about these yield levels. They paper over a lot of mistakes. When you make a mistake at zero yields, that's highly punitive. If you make a mistake today at 5%, that softens the blow considerably,” he said.
Are bonds still good diversifiers?
Last month, Martin Coucke, co-manager of the Schroder Strategic Bond fund told Trustnet that “the diversification characteristics of bonds tend to come back when inflation goes back to close to target” and so investors should view the asset class more for its income potential than its diversification benefits.
Peters was less sure, suggesting that bonds should provide some diversification from here, even if inflation remains above central banks’ 2% target.
“Now, with yields much higher, I think there's greater scope for bonds to do what they're supposed to do as a diversifier. [For example] I can't see a situation where we enter a hard recession and bonds don't do well, at least the front end.
“That being said, the debt and deficit dynamics I keep talking about make it trickier, and I'd still want to avoid the back end. So having a lot at the long end of the curve is probably not the best place to be.”
Where should investors look along the yield curve now?
While the short end of the curve should hold up well in a recession, right now we are not in that scenario. As such, Peters said he is focusing on the “belly” of the yield curve, which he described as shorter duration than 10 years but further than a year or two.
“That applies to both corporate debt and sovereign debt,” he said.
Among his credit holdings, Peters tends to be focused on the five-year and shorter part of the market. This is similar for government debt.
He also warned of going too far along the curve into anything around 30 years – an area where PGIM is underweight.
Peters said the longer to maturity a bond is, the more worried he becomes as it is “further away from central bank policy”, with more exposure to higher rates.
Additionally, he said the term premium – the extra yield on offer for owning a bond with a long maturity – “needs to increase” as, over time, investors “will expect more compensation to own that risk out the curve”.
The final worry with long-dated bonds is inflation, which remains higher than central bank targets, yet the reaction from bond markets has been “overly muted”, he warned.
If there are “any cracks in the central bank credibility façade – given that most sovereigns will be operating above inflation targets for quite some time – that'll manifest itself most prevalently in the [long end of the curve]”.