Bonds have not become a perfect diversifier again in every environment, but they are in a much stronger position to play that role than they were a few years ago.
The inflation shock of 2022 showed clearly that when inflation is the dominant risk driver, equities and bonds can struggle at the same time.
But Craig Veysey, fixed income lead at Guinness Global Investors, says today’s starting point is different.
Higher starting yields provide a much more meaningful income cushion against price volatility and modest yield increases.
“That matters because it means investors are being paid more to hold duration than they were in the near-zero-rate era,” Veysey says.
“At the same time, as the macro backdrop becomes less dominated by inflation alone and more influenced by growth risk and recession probability, the conditions for bonds to act as a genuine portfolio stabiliser are more plausible than they were in 2022.”
Diversity in diversification
The key caveat, however, is that not all bonds diversify equally, so portfolio managers must pay attention to the types of credit, as well as geography and duration.
Veysey explains that core developed government bond markets can still provide strong diversification, particularly when starting yields are already attractive, while longer-duration bonds can offer significant upside in a genuine risk-off move if yields fall from elevated levels.
Higher-quality corporate bonds can also act as a useful diversifier, provided spreads are wide enough to compensate for the credit risk.
“By contrast, as you move down the credit scale, lower quality and more cyclical bonds are much more influenced by the economic cycle and can behave in a more equity-like way, particularly when credit spreads are tight,” Veysey adds.
Case for global bond exposure
At Evelyn Partners, Dan Caps, lead portfolio manager of the Index MPS range, says they have a global outlook for their fixed interest portfolios, with US treasuries in particular always having a big role to play.
Despite concerns around the US deficit, Caps says T-bills are still vital safe haven assets.
He explains: “With credit exposure, global allocations allow us to access different yield curves and interest rate environments.
“However, whenever we look beyond sterling issues, whether this is in credit or sovereign issues, we prefer to hedge our currency exposure to maintain the relatively low volatility characteristics of the asset class.”
While portfolios can be too UK-centric, both in fixed interest and equities, Caps says that current yields on gilts and UK corporates are still attractive relative to other developed markets.
He adds: “In the current conditions, there is some argument in maintaining a reasonable degree of exposure to sterling-denominated fixed interest.”
Stronger fundamentals in EM
When it comes to the investment case for emerging market debt, Carlos Carranza, a fund manager at M&G, notes that a great deal has changed across emerging markets over the past decade, with many countries building substantial resilience buffers that are now increasingly evident.
EM central banks in particular have demonstrated exceptional monetary policy discipline and have maintained historically high real policy rates, which helps insulate currencies from external shocks.
“For example, average real rates in EM were around -3 per cent in 2022, during the height of the global inflation shock,” Carranza says.
Leave a comment