Feature – Volatility
year where bonds have registered their worst year in the last half century, and perhaps ever, it might be strange to say that ‘bonds are back’, but it’s true,” he says. “The flip side of declin- ing bond prices is, of course, increasing yields, which means higher future returns.”
Tina to Tara That is a good starting point. Looking back further, beyond the recent market crisis, it had become common to cite TINA – There Is No Alternative [to stocks] in portfolio construction. But that has quickly changed to TARA – There Are Reasonable Alternatives. And those alternatives include government bonds offering yields of 4%, high-quality corporate bonds offering returns of 6% per annum, and lower-quality bonds offering up to 9%. “Until recently such future return prospects probably weren’t available, even in the riskier parts of the stock markets,” Mikul- skis says. This is vitally important. It means bonds can again justify their place in a portfolio on, it should be noted, return grounds, not just as a hedge against falling stock markets. “It’s also good news for lower risk investors who can now command much better returns at low levels of risk than a year or so ago,” Mikul- skis adds.
As possibly another interpretation of this, the relative valuation of equities versus bonds has moved in favour of bonds. Equity valuations look to have largely normalised, says Bar- clays, with the MSCI Europe trading at 11x forward price/earn- ings, which is 23% lower than the long-term median. “Given the valuation adjustment, positioning and cycle risks, we think bonds offer a more credible alternative to equities now,” Bar- clays said in a statement.
Yield watch Even when you consider the market crisis itself, it has had an impact on bonds – for the better, from an investor perspective. Matthew Russell, a fixed income fund manager at M&G, says because the moves in yield have been so pronounced, those bonds now have less sensitivity to further increases in yields. “If yields go higher, yes you will still get hurt, but not by as much as you would have previously,” he says. “If yields fall, you will end up gaining more in capital value than you previously would have too.”
This dynamic is, unsurprisingly, also at play in the longer-dat- ed world of gilts. “Last December, 40-year UK government debt was trading just below a 96 cash price. Now you can pick those bonds up in the 20s. Not a bad relative value trade for the long-term investor,” Russell says. And given the government’s shift in direction following the mini budget, with Jeremy Hunt replacing Kwarteng as chancel-
26 | portfolio institutional | November 2022 | Issue 118
In a year where bonds have registered their worst year in the last half century, and perhaps ever, it might be strange to say that ‘bonds
are back’, but it’s true. Dan Mikulskis, Lane Clark & Peacock Partnership Investments
lor and rejecting ‘almost all’ of his economic policies, the evi- dence is that long-term UK bonds are to outperform their US and German versions, according to UBS. “This structural nar- rative of tighter monetary and fiscal policy should be a much stronger driver of long-end gilts,” UBS wrote in an outlook. It could be said, as one or two economic historians have noted, this is in-line with the power the bond market has – a power that is evident over centuries: and one that Truss and Kwarteng would have been wise to have recognised. For example, it was bonds that helped secure the Duke of Wellington’s victory at Waterloo by raising the funds to hire mercenaries to join the fight. Wars have been fought as a result of finance raised through bonds: particularly the two world wars. More recently, when Covid shut the world down, governments raised hundreds of billions of pounds and dollars through bonds to maintain stability in the financial system. Which it broadly succeeded in doing.
Major challenges
Of course, for some pension schemes it has been a challenging time on the bond front. Mark Fawcett, Nest’s chief investment officer, puts some perspective to this theme. “This year has seen investors dealing with rising interest rates and increasing inflation. We are seeing sharp declines in corporate bond pric- es – and rises in yields – due to an increase in government bond yields and credit spreads. All of this poses major chal- lenges for economies, and investors have become more con- cerned that a recession is looming.” But he too diverts back to the attraction of bonds. “We believe
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