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People walk past the Bank of England in London on September 29. The Bank of England set aside £65 billion (US$73.3 billion) to buy bonds in an attempt to stabilise Britain’s economy, underlining the turmoil in bond markets. Photo: EPA-EFE
Opinion
Macroscope
by Chris Iggo
Macroscope
by Chris Iggo

Market shake-up will help bonds regain their safe-heaven status. That’s good news for investors

  • The end of quantitative easing could turn out to be a good thing for bond investors as low or negative yields could be a thing of the past
  • With higher yields, there is more chance that bonds will perform positively when riskier assets such as equities are falling in price
Chris Iggo
Chris Iggo
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It is hard to believe how much global bond yields have risen in 2022. As of the close of markets on September 28, the yield to maturity on the US Treasury 10-year note – arguably the global benchmark rate for government bond markets – stood at 3.7 per cent. It was just 1.5 per cent at the end of 2021.

In Europe, government bond yields started the year in negative territory and have risen by more than 200 basis points. The moves have been equally dramatic elsewhere. Emerging-market US dollar-denominated government bond yields, as tracked by the JP Morgan Emerging Market Bond Index, are up by more than 4 per cent.

After being in a period of very low yields for many years, the world has been quickly catapulted into something that looks more like the period before the 2008 global financial crisis. This abrupt shift in the global interest rate and bond yield environment represents a regime change for bond investments.

First, investors have suffered massive losses on bond portfolios as total returns in bond markets have been the worst on record in many cases. This has been a shock as bonds are supposed to be relatively safe assets, usually held in multi-asset portfolios to dampen the volatility of equity holdings.

Historically, most of the time bond and equity returns have been negatively correlated. That has not been the case this year. Bond markets have not provided a safe haven.

Why stocks and bonds are moving in the same direction - down

Second, the bond market has presented increased volatility. Bank of America publishes a “bond volatility” index based on the implied volatility derived from option contracts on US Treasury securities. The level of that index is higher than it was during the outbreak of the Covid-19 pandemic and has only been higher during the global financial crisis itself in 2008.

Third, bond yields are still rising. They are rising because of the global inflation shock and the fact that central banks are determined to squeeze global demand to bring down inflation, recognising that it is not transitory. That means calling a “top” in official interest rates and bond yields is difficult.

The situation is not helped by central banks such as the US Federal Reserve and the European Central Bank moving from being bond buyers during the period of quantitative easing to being bond sellers, or at least no longer being buyers. The dynamics are negative.

It is unlikely that the world will see very low bond yields again. The era of quantitative easing is over, which means a major distortion in the pricing of capital is gone. This could turn out to be a good thing for bond investors. Once they have accepted 2022’s losses, the outlook is more encouraging.

Interest rates will peak in the coming quarters as the global economy slows and inflationary pressures recede. We are already seeing commodity prices ease and the supply issues that were caused by pandemic-related lockdowns continue to abate. Bond markets will anticipate the peak in rates, stemming negative price action.

More importantly, new investments in bonds are being done at much higher levels of yield. Bonds issued today with higher coupons than would have been the case at the beginning of the year are unlikely to see their prices fall by anything like the extent already seen this year. They also provide investors with a much higher level of income through higher yields.

When attributing total returns in bond portfolios in recent years, much came from price appreciation as bond yields fell, with income contributing a relatively smaller amount. Going forward, that will be reversed. Income will be much more important. This is true for government bonds and even more so for corporate bonds, where yields are higher because of the additional risk premium associated with lending to a company rather than a government.

I also think bonds will regain their safe-haven status. With higher yields, there is more chance that bonds will perform positively when riskier assets such as equities are falling in price. The negative correlation will be restored, which is good news for multi-asset investors.

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These are tough times in bond markets. We have seen distress anywhere from the biggest, most liquid markets such as US Treasuries to the less liquid, more niche markets such as US dollar-denominated Asian credit. Looking forward, however, fixed income offers value.

The dominance of US dollar-denominated bonds means there are lots of opportunities for Asian investors. The United States will lead the way, with yields initially stabilising and perhaps easing back. Asian issuers of dollar-denominated bonds generally provide much higher yields than on US Treasuries and hold the promise of better total returns going forward.

While the backdrop might be more challenging with higher inflation, more active central banks and increased volatility, this is important for us to rethink the role of bonds in blended portfolios. This brave new world means diversification is as important as it ever was.

Chris Iggo is the chief investment officer for core investments with AXA Investment Managers

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