4 Reasons to Back Bonds

High prices and low, or even negative, yields make some bonds appear unattractive to investors, but here are four reasons not to ditch the debt

James Gard 21 October, 2020 | 1:08AM

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Bonds have had a good run already this year, the question for investors is whether it can continue. Here are some reasons why bonds should still be part of a balanced portfolio.

1. Volatility Could Return
The global economy’s recovery from the pandemic itself and the knock-on economic effects have not been linear: some countries, such as Germany and China are making progress, while India and Brazil are still battling with a healthcare crisis. The rally in risky assets that has emerged since the pandemic - helped by huge levels of government stimulus - could be running out of steam, as shown by the recent sell-off in tech stocks.

A stock market collapse of the magnitude of March 2020 is hard to imagine at this stage but markets can turn very quickly, especially with infection rates rising again and the US election looming in November. A no-deal Brexit is also a increasing possibility that investors have to factor in as a destabilising economic event. With such an uncertain outlook, bonds can provide some ballast for a portfolio, particularly in a downturn. 

2. Don't Rule Out Negative Rates
Central banks have not ruled out the idea of negative interest rates as a last resort to jumpstart the economy. Bond markets are currently pricing in this move as a possibility, which is keeping yields low and prices high. A decision to embark on negative rates from one of the world’s biggest central banks would trigger another rally in bonds and a capital gain for those already holding them.

Whether negative rates are pursued or just remain an idea, we are likely to be stuck with a low-rate environment. “Ultimately, interest rates are going to remain low for a long time to come. Central banks have made that very clear," says Ariel Bezalel, manager of the Gold-rated Jupiter Strategic Bond fund.

Bonds reflect inflation expectations too, and inflation is bad for bonds because it makes their yields look even worse than they are already (for example, a bond paying 0.1% if inflation is 2% looks seriously uncompetitive). While the return of inflation is something investors should be wary of, there is little evidence of it building at the moment. 

Bezalel says demographics and debt are key to keeping inflation low. As populations age, fewer people are in the labour market, and that holds back growth. And debt, both corporate and government "weighs like a heavy hand on economic activity".

3. Too Much Risk is Priced in 
In this highly uncertain environment, corporate bonds yields are reflecting a pick-up in company defaults. That could come to pass as the recession starts to bite, and particularly if another lockdown is implement, but with the first and second quarters out of the way, is the worst over for the corporate sector?

Gita Bal, global head of fixed income research at Fidelity International, says: “Against a more positive economic backdrop - even one that may be beginning to level off - many companies will have strong enough balance sheets to survive another six months of local lockdowns. A smaller, but significant, proportion should be unaffected by any withdrawal of government support and able to handle an increase in infection rates.”

Richard Woolnough, manager of the UK-based M&G Corporate Bond fund, believes that the lower end of the investment grade market – BBB- or Baa3 – is “an area of huge potential for excess returns” because investors are worried about downgrades from credit rating agencies that could tip the bonds into “junk” or high-yield status, sparking a drop in price and rise in yield.

4. Portfolios Need to be Balanced
A simple 60/40 portfolio (60% in equities and 40% in bonds) has served investors well for decades. Analysis by Morningstar shows that the strategy has proved resilient even in times of market stress, such as the 2009 financial crisis and the March sell-off. Whether this outperformance can continue is hard to predict but bonds have certainly proved their worth this year. The simple theory goes that when shares fall, bonds rise – and that’s exactly what has happened in 2020.

Morningstar experts Tom Lauricella and Christine Benz say: “A smart allocation to bonds can make the difference between a portfolio with scary ups and downs that spook long-term investors out of the stock market, leaving a retiree short on the money needed to pay bills, and a more stable and diversified portfolio that can deliver the outcome an investor needs to pay expenses.”

Why are professional investors buying bonds which offer terrible income and in some cases guaranteed losses? With much of the post-war generation entering or about to enter retirement, pension funds need bonds to preserve capital and match long-term liabilities, something that equities simply cannot do. Governments are also issuing records amount of debt to pay for the trillions they are spending to tackle the coronavirus fallout, which is why central banks are stepping in to buy it. As the saying goes, "don't fight the Fed".

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James Gard

James Gard  James Gard is subeditor for Morningstar.co.uk.

 

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