There are hopes for an improved picture for bonds in 2024 as the rate hiking cycle turns. In this article we look at the case for bonds, consider whether the 60/40 portfolio could make a comeback and look at our best ideas to play the bond market through funds.

ARE BONDS POISED FOR A RECOVERY?

As central banks signal an end to the interest rate hiking cycle Investors might be thinking the prospects for their fixed income investments look quite promising.

Markets have repriced inflation expectations following sharp central bank interest rate hikes and bonds have experienced a scary drop in prices, especially those with longer maturities.

Why play bonds through funds? 

Because most corporate bonds have to be purchased in large denominations, they principally remain the preserve of institutional investors. For both this reason and in the interests of diversification, there is logic in using funds to gain exposure to the bond market. There are a large number of products available which target all different parts of the fixed income market.

In fact, the last two years have been one of the worst on record with cumulative falls in price for longer duration bonds exceeding the brutal drawdown (peak-to-trough fall) seen in the financial crisis.

WHAT IS DURATION?

Duration, based in part on the length of time until a bond matures, can help predict the likely change in the price of a bond given a change in interest rates.

For every 1% increase or decrease in interest rates, a bond’s price will change approximately 1% in the opposite direction for every year of duration.

For example, if a bond has a duration of five years, and interest rates increase by 1%, the bond’s price will decline by approximately 5%. Conversely, if a bond has a duration of five years and interest rates fall by 1%, the bond’s price will increase by approximately 5%.  

The lower a bond’s coupon (interest paid as a percentage of the face value) and the longer the time to its maturity (when capital is returned) the more sensitive a bond’s price is to a change in interest rates.

Higher duration bonds expose investors to the risk of inflation for longer which explains why long duration US treasuries have performed so poorly in the last two years.

Is the 60/40 portfolio strategy still valid?

For the last 40 years, bonds have provided ballast against falling stock markets, a relationship statisticians describe as a negative correlation. It essentially means they move in opposite directions.

Asset prices can also move together perfectively in lockstep, (positive correlation) or there might not be any strong relationship at all (zero correlation).

The success of the popular 60-40 portfolio (60% equities, 40% bonds) has largely been due to equity and bond prices moving in opposite directions.

Take a typical bear market. Let’s say equities fall 30% and bond prices move up 10% as yields drop. A £100 portfolio with 100% in equities will fall to £70.

A 60/40 portfolio will see its equity portion fall from £60 to £42 (60x 0.7) while the bond portion will rise to £44, (40 x 1.1) giving an overall value of £86.

The strength and relative stability of bonds reduces the overall loss to 14%. The all-equity portfolio needs to gain 43% to get back to £100 (100/70) while the 60/40 only needs a 16% gain (100/86).

The negative correlation relationship between stocks and bonds is strongest in government bond markets. Corporate bonds act more like stocks because of the credit risk associated with investing in company debt.

One aspect to be aware of is that corporate bonds of lower quality are more susceptible to losses during a recession as weaker companies struggle to generate enough cash to service debts.

In conclusion, there is a good chance bonds and stocks re-establish their negative correlation as interest rates fall but there is an outside chance that markets have moved into a new paradigm.

THE BULLISH CASE FOR INVESTING IN BONDS

If interest rates are close to their peak in the current economic cycle a case can be made for locking in 4% plus yields on 10-year UK and US government bonds.

Markets are anticipating as many as six interest rate cuts from the Fed this year which looks too aggressive relative to Fed forecasts of three cuts.

There are two justifications why the central bank might cut rates. First, if inflation continues to fall towards target, not cutting rates increases the real rate of interest (nominal rate minus inflation) which tightens financial conditions.

Given all the good work done so far to create the conditions for a soft landing, it would appear self-destructive for the Fed to inadvertently push the economy into recession.

Second, if the economy slows faster than anticipated it makes sense for the central banks to begin cutting interest rates. In any case Fed chair Jerome Powell has indicated the bank will not wait for inflation to return all the way back to 2% before cutting rates.

In both scenarios bonds should do well if inflation remains well behaved. Investors can lock-in a decent yield and potentially see capital gains as rates fall and prices rise. Another factor to consider is money flow.

There is an estimated $6 trillion of cash sitting in US money market funds according to Bob Michele, head of global fixed income at JP Morgan.

These investors are happy clipping 5.5% coupons in the current environment argues Michele but will quickly move into bonds when interest rates come down.

Passive Exposure

Investors interested in getting broad exposure to global bond markets might consider the iShares Core Global Aggregate Bond ETF (AGGU).

This £2.4 billion fund invests in more 13,000 issuers and tracks the Bloomberg Global Aggregate Bond index for an annual charge of 0.1% a year.

THE BEAR CASE

There is no guarantee inflation will return to pre-Covid levels. Sticky, volatile inflation is the enemy of bonds as it eats away at the purchasing power of fixed income.

Economist Mohamed El-Erian argues the combined effects of deglobalisation (more expensive supply chains) and the transition to a green economy imply higher levels of inflation than the past.

The investment team at capital preservation fund Ruffer Investment Company (RICA) are in the same camp. They argue markets are too complacent on inflation risk. This matters for bond investors because history shows that during periods of higher inflation bonds do not provide protection against equity market turmoil.

Under the scenario where inflation remains elevated and more volatile than in recent years bonds may struggle to perform. Longer duration bonds will be more vulnerable to the effects of inflation than shorter duration bonds.

BOND FUNDS TO BUY

Artemis Strategic Bond Fund Inc (BJT0KT2)

The £1 billion fund has a flexible mandate to invest across fixed income markets as the economic cycle turns and market conditions change. It invests in government bonds, investment grade bonds, and high yield bonds.

The managers aim to preserve capital in difficult times and to profit when conditions improve. The fund has outperformed the Bloomberg Global Aggregate Bond Index over three, five and 10 years.

The Artemis team have a positive view across the whole spectrum of bonds. In a recent update they said bonds of almost any variety are a buy and high yield bonds are attractive under almost any scenario.

The fund typically holds between 100 and 130 positions and is well diversified across different sectors.

The portfolio has around 73% exposure to corporate credit and the rest to government bonds. The fund has a 30% weighting to credit of the highest quality companies, 41% to companies on the lowest rung of investment grade and around 5% in the lowest quality.

The underlying yield is 4.3% and the ongoing charge is 0.59% a year.

Invesco Bond Income Plus  (BIPS)

This £300 million fund is managed by Rhys Davies who is supported by Edward Craven of Invesco’s fixed income team which, combined, oversee assets worth £28 billion.

The strategy is to maximise income without taking undue credit risk based on company specific research, taking a two-to-three-year view.

Performance has been good with net asset value outperforming Morningstar’s Flexible Bond category over one, three and five and 10 years. The portfolio tends to be diversified across more than 160 issuers with the top 10 currently representing 37.5% of net asset value.

The biggest sector exposures are financials (around 27% of net asset value) and insurance (8%) followed by automotives (7%), food and beverage (5%) and telecoms (5%).

At the end of December 2023, the fund had a trailing yield of 7.5% and a yield to maturity of 8.6% which is higher than the ICE BofA European Currency High Yield index.

Yield to maturity is the expected yield including capital gains (the portfolio’s average price was 92) and income. The fund has a duration of around four years.

The ongoing charge is 0.86% a year and the shares trade at a 1.27% premium to net asset value.

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