For many years, the textbooks have told us that you should combine equities and bonds in a portfolio because they are negatively correlated and therefore when one does badly, the other will do well and help smooth out the bumps.
The theory is all well and good until bonds don’t behave as they should and start falling back when equities do too. This is exactly what we have seen during 2022 where bonds have offered no kind of protection whatsoever, with equities outperforming government bonds by a big margin.
So far this year the FTSE All Share is down by around 2%, but UK government bonds have fallen by a mighty 20%.
Since the financial crisis, global economies have benefited from ultra-low interest rates and the enormous buying of assets by central banks as governments have needed to issue massive amounts of debt to firstly deal with the crisis and then the global pandemic.
However, this year there has been a dramatic shift in the economic landscape with inflation becoming rampant and central banks scrabbling to raise interest rates to try and keep it under control.
The difficulty is that bond prices and interest rates are intrinsically linked. As interest rates increase, bond prices fall. The sensitivity to this adjustment is measured by duration, which means how long a bond has to run until maturity.
Over the past decade, with interest rates being at such low levels, governments have done exactly as they should have done, by issuing lots of long-dated debt. This locks in a low rate of interest for the duration of the debt, which in theory benefits the finances of the nation.
Many companies have also done the same, issuing long-dated debt to help secure cheap, long-term finance for their companies. EDF, the state-backed electricity company in France, was the most extreme example of this when it became the first company to issue a 100-year denominated bond back in 2014 with a coupon of 6% per annum. Investors snapped it up.
What this huge issuance has done over the years is change the duration of the benchmarks with the average duration increasing significantly. In the UK, the duration of the government bond index has increased from around seven years to 11 years.
Why does this matter? Well, as interest rates increase, government bonds will now fall much further than they’re used to as they have become more sensitive to rates. The longer the duration of a bond, the more sensitive it becomes, and sensitivity equates to volatility and risk.
This is perfectly illustrated by looking at the performance of different durations of UK government bonds this year. Short-dated bonds – those maturing in less than five years – have fallen by around 4.5% while long-dated bonds – those maturing in more than 20 years – have fallen by a remarkable 33% in 2022.
The textbooks tell us that government bonds are one of the safest investments there is, with risk just above that of cash. I’m not sure anyone in long-dated bonds who has just seen their investment values fall by 25% would agree right now.
The difference with bonds compared to equities is that if you hold them until maturity, you should receive your coupon payment every year as well as getting your capital back, so all is not lost.
But again, we are consistently told that as investors approach retirement they should de-risk their portfolio and move out of ‘risky’ equities and into ‘low risk’ bonds. Anyone following this strategy in 2022 will no doubt be feeling pretty upset.
For more cautious investors, portfolios typically have a much higher allocation to bonds than higher risk portfolios. This has led to the unusual situation where lower risk portfolios are currently underperforming some higher risk portfolios in a falling market. For many, this will fall outside of their expectations and therefore investors will need to look carefully at their portfolios, ensuring that they fully understand what they hold and how it will behave in this new environment.
With inflation running at 40-year highs, some commentators are looking back at the 1970s and wondering if this is history repeating itself. While clearly there are some similarities with high inflation, increasing interest rates and high energy prices, it’s too much of a simplification to draw major, direct comparisons.
However, investors in bonds and those in low-risk portfolios need to be prepared for more bumps in the road than they will have been used to after a 40-year bull market in fixed interest.
Ryan Hughes is head of investment partnerships at AJ Bell. The views expressed above should not be taken as investment advice.