With yields so low (and seemingly rising), inflation so high, and central banks turning more hawkish, it seems that the risks in fixed income are asymmetric. Meanwhile, there seem to be a promising opportunity set in alternative assets.
Real assets tend to have favourable characteristics in an inflationary environment, and absolute return assets seek to provide a portfolio with steady, reliable gains, fulfilling a role that bonds are often assigned.
Due to these factors we are currently overweight alternatives and underweight fixed income, but there is a valid question: "Why hold any bonds at all?"
Despite feeling that the outlook for bond returns is challenging, we feel that they can still offer significant benefit in a balanced portfolio.
Firstly, they offer diversification. There is a lot of discussion over whether the correlation between bonds and equities will remain negative – research in our Global Outlook publication suggests that elevated core inflation is associated with a switch to a positive correlation – but no one assumes that the correlation is +1. As the saying goes: diversification is the only free lunch in finance.
Secondly, the negative correlation that has existed is not a given, but most of the time the correlation is not of huge importance – it is nice to have, but there have been periods of history with a positive correlation before, and there likely will again.
When the negative correlation does tend to matter is in times of duress. Thus far the risk-off aspect of bonds has held up – it has managed to reduce portfolio damage when equities are in trouble.
Thirdly, on all but the most exceptional days, bond volatility is significantly lower than that of equities (and most other asset classes). Holding bonds can therefore act as a ballast that allows one to invest in other more volatile areas – with potentially higher returns – while keeping the portfolio variance within an acceptable range.
Fourthly, they have the additional benefit of allowing relatively low-risk exposure to different currencies. If a foreign bond were to lose, say 5%, but the currency to strengthen by 10%, then this would still be a profitable trade. There are perhaps other, preferred ways to gain currency exposure, via derivatives or other asset classes, but bonds can be an option.
Concerns over finding a buyer for government bonds are also potentially overstated – though of course it is the marginal buyer that sets the price. There are a number of parties who are, as things stand, essentially forced into owning government bonds.
Banks need sufficient high-quality collateral, pension funds need to match their liabilities, and some fund managers are required to own bonds to meet their clients' mandates.
Part of the appeal of fixed income is in the name: the income is fixed. So long as you are confident that the issuer won't default, either partially or in full, then you know what you will be paid and when.
If you own a gilt and hold it to maturity, then you can be confident that you will be paid the expected number of pounds. If the yield fluctuates along the way, the nominal value will move, but these gains or losses are not realised and the amount received is the amount expected. Some investors still believe that this certainty is worth paying for.
Despite our underweight recommendation for bonds, and the potentially difficult outlook for the asset class, we believe that exposure to an active fund can be a boost to a portfolio. Active exposure can, when done well, mitigate some of the concerns associated with fixed income investments currently.
Waverton's bond funds seek to invest in bonds in an intelligent way, not just manually replicating an index as many funds do. For forty years a buy-and-hold strategy has worked well in bonds, but now successful funds need to be active, flexible, nimble, and opportunistic.
The Waverton funds they look to supplement the core of the portfolio (which is currently made up of long-duration government and short-duration credit exposure) with a sophisticated tail-hedging strategy.
This is something most bond funds lack, and something beneficial to have, especially given that there are currently material tail risks at both ends of the risk on/off spectrum, in form of a looming global tightening cycle and tensions on the Ukrainian border.
You can still make money with bonds and a good bond fund can be a very useful addition to your portfolio.
Jeff Keen is head of fixed income at Waverton.The views expressed above should not be taken as investment advice.