Government bonds have historically provided investors with a stable income and diversification within a multi-asset portfolio.
In the old days, investors could rely on equities to perform well in a risk-on environment, while government bonds delivered in a risk-off scenario. However, the asset class has surprised on the upside in the extraordinary market conditions that took hold from 2009 onwards.
A 30-year bull market for bonds, buoyed by quantitative easing (QE), resulted in government bond prices looking expensive, while yields remained low. This made it difficult for income investors to allocate to the asset class; they were forced to look elsewhere for an attractive yield.
Fortunately, this trend is now starting to reverse. Yields have started to rise and prices have fallen in anticipation of higher inflation and further interest rate rises. In October, the 10-year US Treasury yield moved above 3%, crossing an important psychological threshold for investors.
Looking ahead, there is the potential for yields to rise and prices to fall further, resulting in capital losses for existing bondholders. However, for some income investors who are approaching the asset class with a fresh perspective, longer-dated gilts and Treasuries are starting to look attractive from a yield perspective.
David Coombs, Citywire AA-rated manager of the Rathbone Multi-Asset Strategic Income Portfolio, recently started buying long-dated gilts when the 10-year yield reached 1.5%. He then topped up at 1.75%.
Nevertheless, this represents a small allocation at 1.4% of the portfolio. In contrast, Coombs currently holds 6.9% of the portfolio in short-dated gilts, offering an 8% coupon.
‘While acknowledging the negative real yields, we do feel the risk of recession in the UK is relatively high so gilts could become a very helpful diversifier,’ he explains.
The multi-asset manager adds he has not been tempted into Treasuries since the 10-year yield breached 3%.
‘This is largely due to recent dollar strength rather than an aversion to Treasuries. In fact, the 10-year is looking attractive, as I believe the Federal Reserve [Fed] may begin to offer a more dovish tone soon,’ Coombs says.
John Stopford, manager of the Investec Diversified Income fund, agrees government bond markets are starting to look attractively valued as yields rise. Although they no longer look expensive in a world of low trend growth, anchored inflation expectations and low official real interest rates, he still has reservations about their role as a defensive diversifier in portfolios.
‘With central banks removing policy accommodation, especially through fading QE, the Fed raising interest rates, increasing the supply of new bonds, and cyclical pressures to the upside, we would rather wait for these markets to reach cheaper levels before adding much exposure, especially as we believe there are other more effective defensive hedges,’ he says.
Although he says 10-year Treasuries are starting to look cheap, he has not been tempted to buy in just yet.
‘We expect them to rise further, through indigestion of new supply, so long as US growth holds up and the Fed remains on a tightening course,’ says Stopford. ‘We are likely to begin adding duration gradually into a further rise in yields, or on signs growth is slowing to a below-trend rate.’
The Investec Diversified Income fund currently has a low duration of around 0.9 years. Stopford prefers to own bonds that pay higher real and nominal yields, where the associated central banks have the scope to cut interest rates in the event of a global recession or bear market. For example, in Australia and New Zealand.
Note of caution
David Appleton, co-manager of the SVS Cornelian Managed Income fund, believes yield curves outside the US do not currently offer an attractive risk-return payoff.
‘The gilt market, for example, offers investors a sub-inflation yield to maturity of only around 1.5%, but has relatively high interest rate sensitivity with an estimated duration of 11 years. A 1% move in interest rates would theoretically cause an 11% change in the market value of the gilt market,’ he says.
‘If long-term interest rates were to move up by 1% to 2.5%, which is still half of what they were pre-crisis, investors could lose more than 10% of their capital as prices adjust.’