How the professionals are responding to the bond market sell-off

"Bond investors are the vampires of the investment world. They love decay, recession – anything that leads to low inflation and the protection of the real value of their loans." 

So said the lauded ‘Bond King’ Bill Gross back in 2012. But while Halloween may be around the corner, bond investors are now having to think twice about what they sink their teeth into as the bond market sell-off that began towards the end of the summer rumbles on.

High sovereign debt levels, heavy corporate borrowing and concerns over the escalating Middle East conflict disrupting energy markets and adding to inflationary pressures spooked global bond investors in late August, sending benchmark yields to multi-year – and even multi-decade – highs.

Many multi-asset funds use bonds as a buffer to offset any drops in the stock market, but the recent bond market rout poses the question of whether they are suited to serve this function, particularly in a higher-inflation environment.

“The recent sell-off in government bonds is another reminder that bonds should not always be relied upon to provide diversification when equities fall,” says Anthony Snowden, private client investment director at Tyndall Investment Management.

“This was a lesson learned from 2022 onwards; the traditional role of bonds as a portfolio buffer has become more complicated as inflation has become more volatile and government borrowing has increased.

“Unhelpfully, this means that yields can rise at the same time as risk assets come under pressure, keeping 60/40 portfolios on edge. Corporate bonds often behave more like equities when spreads widen sharply.”

Getting 'selective' again

Snowden says the answer is to be selective about the different roles bonds play in a portfolio, while increasingly supplementing them with other forms of protection.

He highlights the Ruffer Investment Company (LSE:RICA) as taking a broad approach to portfolio protection instead of simply relying on government bonds to protect the portfolio.

“At the end of August, the portfolio held 30% in nominal bonds and a further 20% in non-UK inflation-linked bonds.,” he says.

“However, the defensive allocation also included 9% in credit and derivative strategies, 5% in gold and precious metals and 2% in commodities.”

“This reflects Ruffer's philosophy of combining assets with different responses to different economic shocks and is particularly relevant in an environment where bonds can fall at the same time as equities.

“Inflation-linked bonds, gold and commodities can potentially provide protection against an inflationary shock, while derivative strategies can provide more explicit downside protection.”

“Lazy assumptions”

Ian Rees, head of multi manager funds at Premier Miton, is not fully sold on using bonds as a diversifier but says there is some merit in it.

“The lazy assumption that many investors made was that bonds would work as a hedge in portfolios when there is a risk-off event,” he says.

“We do not believe they will act in that fashion. They are still a risk asset and are likely to perform poorly in a risk-off event, the same as other risk assets.

“That said, they are a lower-risk asset compared to many other assets – including equities – so you should lose less from holding some bonds, justifying an allocation for risk diversification purposes.”

Rees adds that the diversification rationale for bonds would come to the fore if the growth outlook were to materially weaken, prompting central banks to reduce interest rates, which in turn would put downward pressure on bond yields.

“Currently it seems this is not necessary – growth and employment figures do not suggest we are facing an imminent growth or recession threat – but as the adage goes, ‘you fix the roof when the sun is shining’,” he says.

“In this case we are being paid a good yield to hedge portfolios from this specific risk rather than a general risk-off event.”

However, Rees says the team is being selective with its fixed income exposure, avoiding longer-dated bonds where there is greater volatility and favouring UK gilts, which sit at a higher yield than US government bonds.

Instead of using an all-stocks gilt index – which buys a proportion of all gilt maturities in the market – Rees likes the GS Acs UK Glt 1-10 Yrs ETF CLG BP Dist (LSE:GBPG) which shortens the overall duration – and hence volatility – of the UK gilts trade.

Asset-backed

To diversify further and tap into an emerging asset class offering higher yields, Rees says the Premier Miton funds hold asset-backed securities (ABS).

“As the name suggests, these are bonds with an assigned collateral in the event of default,” he says.

“They can be more complex than general corporate bonds due to the structural or covenant complexity that comes with them, but because of this, they can pay a higher yield than equivalently rated corporate bonds without the collateral protections."

Robert Plant, portfolio manager, multi-asset solutions at Columbia Threadneedle Investments, is also a fan of ABS to broaden his sources of diversification, and recently added a dedicated ABS fund to some of his portfolios.

Given how niche they are, dedicated ABS funds are not always readily available to DIY investors. 

But they can get some exposure, either via certain multi-asset funds or via flexible bonds that invest here. 

One name in the second camp is MI TwentyFour AM Dynamic Bond I Acc (B5VRV67), which has a 14% allocation to ABS.

Time to trade?

Meanwhile Gautham Samarth, multi-asset fund manager at M&G Investments, admits that soaring yields have been a headwind to balanced portfolios, but says the volatility in bond markets has offered compelling trading opportunities to offset this.

“As such, we have also seen value in holding cash, where higher real interest rates offer an attractive source of income while preserving flexibility to trade tactically,” he says.

“Alongside this, strategies such as foreign exchange carry and absolute return strategies can provide diversification because their returns are driven by different factors to traditional bond and equity markets."

We recently looked at some of the funds using more esoteric approaches and how they have fared.

Still backed for ballast

For Sacha Chorley, portfolio manager at Quilter, conventional bonds are still a defensive play.

“Fixed income remains a core part of the mix of assets we use to add diversification in portfolios, alongside alternatives and of course cash,” he says.

“In a growth shock we still would expect nominal bonds to perform well, assuming monetary policy loosens and headline interest rates are cut,” he says.

“Clearly global growth remains ok right now and further rate hikes are expected in order to quell inflation, but that does not mean fixed income as a whole asset class cannot provide the defensive qualities we come to expect from it.”

In the current scenario, with real yields positive across the curve in the major developed economies, Chorley says inflation-linked bonds also offer some protection against higher inflation.

“Of course, there is a risk that inflation treads higher still as events in the Middle East continue with no resolution and elevated energy prices become baked in across the economy, while structural demand from data centre construction and reshoring are also potential drivers of commodity prices, and hence inflation,” he says.

“As such strategies such as Vanguard UK Infl-Lnkd Gilt Idx £ Acc (B45Q903) provide investors with a good option to enhance overall diversification beyond traditional nominal bonds, particularly given the current inflation outlook within the UK.”

Chorley also points out that allocating to global rates managers [focused on government bonds] can be an effective way to access developed market bonds while also leveraging their ability to take shorter-term views as opportunities arise across different yield curves and at different maturities.

“The recent volatility in bond yields makes it a good opportunity for active management to hunt out discrepancies in the market and take advantage of any overreactions,” he says.