Vanguard says ‘bonds are back’ following worst spell for 150 years

Yields now deliver inflation-beating income for investors with a five-year investment horizon. 

An historically bad first half of 2022 for the bond market means that opportunity awaits for investors looking for high yields and the chance of capital gains.

Vanguard, the American fund giant, argues that “bonds are back” following the worst six months for fixed income in at least 150 years.

Emerging market bonds have fallen about 20% this year, while US high yield and global corporate bonds are down around 15%.

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However, yields, which move inversely to price, now offer income above inflation forecasts for the next five years.

Vanguard’s active fixed income team said: “Positive real yields now exist, with bond yields higher than expected inflation over the next five years and beyond. Corporates, municipals, high yield, and emerging markets present more opportunity than at any time in the recent past.

“TINA (there is no alternative) has resigned: bonds offer an alternative with reasonable income again and have re-established their role as a portfolio hedge to equity risk."

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The fund group says that investment grade bonds, which are the least likely to default, can now yield 5%, with pharmaceuticals, utilities and financials offering the best value.

With a 20% decline in emerging market bonds so far this year, there are attractive entry points among the highest-quality borrowers, it adds.

Meanwhile, riskier “high-yield” bonds now yield around 9%. Vanguard said: “Behind the improving valuations lies a fundamental credit picture that remains strong even in the face of a likely economic slowdown ahead.

“Long-term investors should cheer — yields above the inflation expected over the next five years or longer exist in the Treasury market for the first time since a brief spike during the initial Covid panic of March 2020. For those looking for tangible income, that exists now, too.”

Moreover, Vanguard argues that bonds have also started to behave as a stable hedge to equities after spending most of the year correlated with risk assets.

“Signs of a weaker economy ahead are likely to validate the role of bonds as a portfolio diversifier. That has been the case over the long term, and we believe it will be going forward as well,” it said.

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Market outlook

The increasing risk of recessions around the world, and the likelihood that inflation has peaked, means investors expect interest rates to begin to fall next year. 

“Markets now see the US Federal Reserve increasing interest rates faster, but pulling back more quickly. Investors expect the US interest rate to peak at 3.5% in December, followed by 0.50 percentage points of cuts next year,” Vanguard said.

Falling interest rates and stable inflation is generally good for bond prices, and would likely therefore provide capital returns alongside the inflation-beating income on offer today.