We have seen some volatility to start 2022. As the world is getting used to living with Covid-19 combined with the events in Ukraine, this is no surprise. The next challenge investors are facing is what is being described as the ‘Bond Bear Market’.
Endorphin Wealth works in collaboration with Oreana, to provide the best investment solutions for our clients. Oreana provide insightful market updates on such ‘Bond’ topics and how they impact investments.
Below is their latest update regarding the current Bond Market situation:
One of the factors making a bad situation worse for investors at the moment is that returns in the so called ‘defensive’ part of their portfolio called fixed interest (or bonds) is going the same direction as the ‘growth’ part – down. This is adverse to the role they are meant to be playing. We have a look at the factors driving this dis-allocation and what it means for investors in diversified portfolios.
Global bonds have faced terrible start to the year. The 6.2% decline in the ‘Bloomberg Global Agg index’, is the worst start to the year since we have data from the early 1990s. It is also the third worst quarter on record since then. In Australia, the broad Australian Composite index has experienced its worse quarter, falling 5.9%.
Global central banks have started hiking rates in response to unexpectedly high inflation readings, pushing yields higher (or bond prices down). It is therefore a challenging time for the asset class many investors define as “Defensive”.
Firstly, it is worth reminding ourselves why we hold different types of bonds, and their role in a portfolio which also typically holds shares, and cash.
Bonds repay principal at a specified date, called the maturity date. This feature is appealing for investors who do not want to lose capital or need to meet a liability at a particular time.
Most bonds provide a fixed income, which is paid at scheduled periods each year. A coupon payment which can be spent or reinvested is sent by the bond issuer. The income return of bonds becomes more attractive as yields increase.
Different types of bonds – issued by governments or corporations – are impacted by macroeconomic and idiosyncratic risks differently to equities. The low and in some cases negative correlation with equities and other assets can help reduce overall risk within a portfolio.
Downside risk hedge
Some bonds – particularly high-quality government bonds like US Treasuries – can help protect against economic slowdowns. During recessions, when interest rates are cut and growth assets are subject to significant downside volatility, government bonds tend to see their yields decline and their prices increase, providing a hedge against the economic risk.
Bond prices can increase for many reasons – including falling interest rates or credit quality improvements. Buying bonds at prices below par and capturing the capital appreciation increases the total return of the bond, which is the combination of the income and the capital appreciation.
Where to from here?
Investors often think as bonds as defensive, or “safe”. But as described above, bonds play many roles in a portfolio. It is important to focus on those roles, and the outlook, particularly in a period where bonds have suffered capital losses.
From here we expect government bond yields to continue to drift higher over the coming 6-12 months. That will be a challenging environment for fixed income. But higher yields will provide higher income, more downside protection, and in time, more scope for capital appreciation.
Endorphin’s internal Asset Allocation views has meant we had already been moving away from government bonds and longer maturity bonds, in favour of shorter maturity corporate bonds. While that has helped, the overall bond market is in a bear market. It has been challenging, particularly over Q1 2022 which is the third worst performance for the asset class since the early 1990s.
We think it is important to avoid knee-jerk reactions within diversified portfolios, we have actively been adjusting bond exposures, and identifying alternative investment opportunities that may help achieve some of the objectives traditionally identified with bonds – income, for example, or diversification.
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