As economies continue to open up, we are expecting a strong rebound in growth, with potentially sticky inflation. When central banks take their foot off the pedal and begin to apply the brakes, bond market returns suffer. The first quarter, which saw a loss of over 4% for US Treasuries – their largest quarterly drawdown since 1980 – is a case in point. With this backdrop, clients are wondering what role bonds should play in a balanced portfolio in the coming years (see On the Minds of Investors: Why and how to re-think the 60:40 portfolio).
There is no doubt that the return outlook for fixed income is challenging. In the past, the coupons that bonds paid at least cushioned the blow of rising rates. For example, during the Fed’s last hiking cycle (December 2015-December 2018), the price of US Treasuries fell by around 2% but the coupon paid over the period more than made up for that loss, such that total returns were still positive at around 4% over that period. Over the same period, global investment grade government bonds managed to return roughly 12%. Today, with starting yields and spreads so low, there is very little income to cushion against rising rates (Exhibit 10).
Exhibit 10 – Low spreads reduce the cushion against rising rates
Fixed income yield cushion
Source: Bloomberg Barclays, ICE BofA, J.P. Morgan Economic Research, Refinitiv Datastream, J.P. Morgan Asset Management. The “income cushion” represents the amount by which yields would have to rise to wipe out a year’s worth of income, and is calculated by dividing the index yield by the index duration. Euro Gov.: Bloomberg Barclays Euro Agg. Government, UK Gilts: Bloomberg Barclays Sterling Gilts, US Treas.: Bloomberg Barclays US Agg. Gov. – Treasury, Global IG: Bloomberg Barclays Global Aggregate – Corporates, EM China: JPM GBI-Emerging Markets Broad Diversified China, $ EMD: JPM EMBI Global Diversified, Global HY: ICE BofA Global High Yield. Data as of 31 May 2021.
It might be tempting then to exclude bonds from portfolios altogether. However, that would lead to much higher portfolio volatility and little protection against unforeseen downside risks. For example, should the virus mutate to the extent that vaccines are no longer effective, government bonds would likely be one of the few assets generating positive returns.
In our view, investors should consider fixed income strategies that have the ability to invest globally in search of greater income protection, and which can move flexibly in the event of changing economic winds.
One global solution that, in our view, looks particularly attractive today is Chinese government bonds, which currently yield over 3% and benefit from a strong credit rating. A relatively low average duration also makes them less vulnerable to rising yields. Chinese bonds have proved to have a low correlation to both global bond and equity markets, making the market a good source of portfolio diversification (Exhibit 11). The Chinese onshore fixed income market is the second largest after the US Treasury market, but its representation in global benchmarks is still small. As its weighting grows, investors should benefit from the rising demand.
Exhibit 11 – Chinese bonds have an increasingly important role to play in a portfolio
Yields and correlations of fixed income returns to equities
Source: Bloomberg Barclays, ICE BofA Merrill Lynch, J.P. Morgan Index Research, MSCI, J.P. Morgan Asset Management. Indices used are as follows: US Treasury: Bloomberg Barclays US Agg. Gov. – Treasury; UK Gilts: Bloomberg Barclays Sterling Gilts; Euro Gov.: Bloomberg Barclays Euro Agg. Government; Euro HY: ICE BofA Euro Developed Markets Non-Financial High Yield Constrained Index; US HY: ICE BofA US High Yield Constrained Index; Asia HY: J.P. Morgan Asia Credit (JACI) Non-Investment Grade; Asia IG: J.P. Morgan Asia Credit (JACI) Investment Grade; Asia Govt.: J.P. Morgan JADE Broad - Asia Diversified Broad Index; China IG: J.P. Morgan CEMBI IG+ China; China Gov.: JPM GBI-Emerging Markets Broad Diversified China. Indices are in local currency unless specified otherwise. Correlations are based on 10-years of monthly total returns of the respective fixed income indices with the MSCI ACWI total return. Data as of 31 May 2021.
Beyond fixed income, investors can look to other alternatives for diversification. Macro strategies can adjust their correlation to equities and other asset classes and move dynamically according to changing market conditions. In periods of uncertainty – in which investors need portfolio protection – macro funds have historically outperformed equities (Exhibit 12).
Exhibit 12 – Macro funds have tended to perform well in bouts of volatility
Macro hedge fund relative performance & volatility
Source: CBOE, MSCI, Hedge Fund Research Indices (HFRI), Refinitiv Datastream, J.P. Morgan Asset Management. Macro hedge fund (total return in USD) relative performance is calculated relative to MSCI World (total return in USD). VIX is the implied volatility of S&P 500 Index based on options pricing. Data as of 31 May 2021.
The real market jitters would occur if a disorderly rise in inflation were to be realised. We view this as a tail risk, but given it would be unlikely to be good for either stocks or bonds, it’s one we should not be complacent about. Real estate and core infrastructure have low correlations to equity markets but their income streams are often tied to inflation, so can serve as a good inflation hedge. Of course, there are no free lunches, and such assets usually come with liquidity constraints, but those who can invest for the longer term may benefit from the inflation protection they can provide.