Three reasons to invest in bonds as inflation soars

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22/07/2022
The bonds sector has faced a difficult environment as inflation soars and interest rates climb from their historic lows. But there are still good reasons to continue to hold them in your portfolio.

According to the Association of Investment Companies, the Debt – Loans and Bonds sector offers an attractive average yield of 7.04%.

However, total returns have been negative over one and three years, with losses of 7% and 1% respectively.

And this year alone, UK investors have seen an 11% drop in the value of the typical bond fund.

Fixed income tends to be seen as safer or less risky than equities – they preserve capital and provide investors with a reliable income stream.

But inflation – more so stagflation – and interest rate rises have created a “perfect storm” for fixed income.

It’s little wonder then that bond funds suffered £458m outflows in June, according to global fund network Calastone. It said this came as “investors absorbed the falling bond prices that accompany higher market interest rates”.

But according to Kyle Caldwell, collectives specialist at investment platform Interactive Investor, while bonds are “more complicated and less exciting than equities, they should not be written off, even in the current challenging environment for the asset class”.

David Coombs, head of multi-asset investments at Rathbones, says while there’s “a time and a place for a range of assets in a portfolio, we don’t think writing off exposure to bonds for the foreseeable future for multi-asset investors, such as us, is appropriate.”

Here are three reasons to continue holding bonds:

Higher yields to compensate investors

Phil Smeaton, CIO, Sanlam Wealth, says that low prices and high inflation have rendered bonds “less attractive investments” but enduring some short-term pain now could lead to higher returns in the future.

He says: “In adversity lies opportunity. Collectively speaking, investors are not very interested in holding fixed income right now. As investors came to realise these heightened levels of inflation are likely to last, they have demanded higher yields to compensate, and consequently bond prices have fallen this year. This means unexpectedly high inflation becomes expected inflation and is priced in by the market. This means that traditionally safe fixed-income securities have suddenly become discount buys – thus creating a better entry point for new buyers.”

Sam Benstead, deputy collectives editor at Interactive Investor adds that the main reason to own bonds was to get paid a stable income every month but this had been a “secondary consideration for investors” as yields were squeezed towards zero – and even went negative in some parts of the market – as prices rose.

He says: “Weighing up rising interest rates and stagflation, this has sent yields higher, finally making income part of the investment case.

“US government bonds with a 10-year maturity now yield around 3%, about six times the yield in summer 2020. In the UK, 10-year gilts are at around 2%, 20 times higher than the 0.1% they yielded in July 2020, their low point.

“Corporate bond yields, and how much they return over the ‘safe’ government bond rate, known as the spread, have also risen. Investors can now get about 4% from the safest corporate credit, known as investment grade, while high-yield or “junk” bonds yield around double that.

“Higher yields mean that fund managers can begin adding better value bonds to portfolios, which increases how much money investors will get paid each month. This increased income can help cushion the blow of rising prices.”

Return of a more ‘typical’ correlation amid recession fears

Equities and bonds tend to have an inverse relationship so when one goes up, the other goes down.

This has been a well-established way for investors to generate returns and protect against market volatility. However, the customary ‘self-balancing’ of a traditional equity and bond portfolio has broken down in recent times, Rob Morgan, chief investment analyst at Charles Stanley explains.

He says this is largely due to the trajectory of interest rates which were cut close to zero during the global financial crisis and then again at the onset of the Covid pandemic. This, along with substantial money printing from central banks, boosted bond and equity markets together.

“Cashflows from both were seen through the lens of a continual subdued inflation and interest rates, meaning investors were willing to pay more for them,” he says.

But he adds that the recent inflation shock has “dealt a considerable and unexpected blow to portfolios”.

“As expectations of a period of higher and longer-lasting price rises intensified, bond and equity markets suffered in tandem. 2022 has thus far been a perfect storm, a period in which almost nothing in a traditional, diversified portfolio has been able to produce a positive return”.

As central banks raise rates to curb inflation – which is showing signs that it is starting to peak – and wage inflation is “way behind consumer prices” leading to weak confidence among consumers, “we can therefore expect difficult times ahead for many businesses as demand subsides”, he says.

Morgan adds: “A chance of recession and a future period when interest rates might be cut – provided inflation comes back down quite quickly – seems likely, partly because the big numbers in the price indices become the new bases from which to measure.

“In a recession companies lose turnover and profits, so the equity market would likely be under some pressure in this scenario, a gloomy one perhaps for equity investors but possibly a brighter one for those holding bonds. The fixed level of income from bonds would start to look more appealing as the inflation cycle and interest rate cycle peaks, although investors will need to take account of any deterioration in creditworthiness, especially in relation to higher risk, higher yield debt.”

Coombs adds that as yields have risen, the risk/reward has shifted for conventional (non-inflation linked) bonds.

“Coupled with this, the backdrop is one of potential economic weakness, which would typically see a further flight to the perceived safety of bonds, and eventually the potential for easier monetary policy again to support weaker economies, both situations supportive for bonds.

“In this environment we believe bonds would again see that more typical correlation with equities and they could provide support to portfolios again if equities falter.”

Diversification and the return of an effective buffer

Morgan says that while there may be some “near-term volatility” affecting both equities and bonds as inflation expectations ebb and flow, “it may be a good time to consider bond exposure”.

“This is with the view that it helps guard the possibility of recession and a sharp fall in inflation that may turn out to be better for fixed income investments than it is for company earnings.

“Stubborn inflation requiring yet more interest rate rises than predicted, or higher rates for longer, would present a more difficult scenario for bonds – and for equities – but this would not seem as likely.

“We believe bonds could once again provide more of a buffer in portfolios as we move through the year,” he says.

Ideas to invest in bonds

Coombs says inflation remains a key factor “as stickier inflation, or economic weakness coupled with very high inflation, is likely to continue to put pressure on bonds”.

“This is why we believe adding incrementally to longer dated bonds is important to manage this risk”, he says.

He adds that he’s seen some interesting bonds out in “companies we are confident can repay their debt, even if the economic environment deteriorates”.

Coombs says: “The bonds mature in two to four years and yield 6-8% per annum, which to us feels an attractive risk/reward proposition. If one can be selective there are some opportunities in corporate bonds in solid companies where yields are suddenly much more attractive.”

Meanwhile Morgan rates Vanguard Global Credit Bond which seeks to provide a moderate level of income through investing in a diversified portfolio of corporate bonds on a global basis.

He says: “The focus is predominantly on developed markets and relatively secure investment grade bonds. The fund was launched in 2017 but forms part of a well-established strategy and draws upon Vanguard’s impressive fixed income capabilities.

“Although best known for its passive strategies, the US fund group is one of the largest active fixed income managers in the world and is resourced accordingly. It is a possible building block for investors who prefer straightforward exposure to the asset class, rather than a strategic, flexible or global bond manager that aims to move around the fixed interest spectrum more aggressively in search of outperformance.”

He also lists the Rathbone Ethical Bond. “The manager, Bryn Jones aims to build a portfolio of good quality investment grade bonds (avoiding the riskiest ‘high yield’ bonds) while applying a broad range of both positive and negative social, environmental and governance(ESG) screening criteria that could appeal to those wishing to invest responsibly”, he says.

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