This year has turned out to be an ‘annus horribilis’ for fixed income markets. UK government bonds – the traditional backbone of a cautious portfolio – returned -19% in the first eight months of the year, with UK corporates registering similar losses.
Central banks around the world have been struggling to contain with soaring inflation, which has meant few hiding places in bond markets. Global corporates, global high yield and global inflation-linked bond indices are all down 13% year-to-date.
The result is an 8.5% loss for the average fund in the Morningstar GBP Allocation 0-20% Equity sector – a painful outcome for clients with the lowest tolerance for losses.
Before focusing on how we think investors should be positioned for the rest of 2022 and beyond – it is worth highlighting the few areas that have worked this year.
Firstly, the weakness of sterling has led to a material boost for unhedged global bond funds. This can be clearly seen in the returns of the Vanguard US Government Index fund – the unhedged share class is up 5%, the sterling-hedged version down 10%. We hold both share classes in our MPS portfolios.
Secondly, local currency emerging market debt returns are flat for the year, having rebounded strongly in August. Inflation is a global issue and many of the large index constituents are facing similar price pressures – for example, Brazilian and Mexican CPI is running at 8.7% while South African inflation is 7%.
The difference with the developed world is that many emerging market central banks have more aggressively tightened monetary conditions. The result is the key index constituents offering bond investors yields in excess of prevailing inflation rates, which is in stark contrast to the UK, continental Europe or the US.
Finally, cash funds have been king in 2022. Our lowest risk MPS portfolios entered the year with around 13% invested in Royal London Short-Term Money Market and the fund’s 0.5% year-to-date return has been a key contributor to returns.
So where best to allocate fixed income investments for the coming months and years?
Today, asset allocation decisions are being made against a very different fixed income backdrop than at the start of 2022. Government bond yields in the UK and US are the highest they have been for more than a decade and credit spreads have widened considerably, particularly in Europe.
Given this higher yield environment, our expected returns for all fixed income assets have risen materially and it is a logical step to begin deploying that cash into higher duration assets.
For us, bonds at the short end of the curve are looking especially attractive. In the US, two- and three-year government bonds are yielding just a touch shy of 4%. At these levels, yields need to rise 200bps over the next 12 months for an investor to lose money from here.
In the UK, two-year bonds are yielding slightly less, at 3.3%, but domestic credit spreads are wider, at around 2.0% at this maturity. This makes UK short-dated corporate funds look good value and we hold Fidelity Short Dated Corporate Bond or the L&G Short Dated £ Corporate Bond index fund depending on the mandate.
We continue to favor emerging market debt – and hold both local and hard-currency. Our preferred implementation method is via active managers like Colchester Local Markets Bond or Barings EM Local Debt. For passive mandates, we own the L&G EM Government Bond Local Currency Index fund.
Index-linked bonds is another area of interest. These bonds’ coupon and principal are contractually linked to inflation and have therefore outperformed relative to conventional bonds this year. However, since their peak in April 2022, we have seen five- and ten-year breakeven rates in the United States falling as investors began to price in a higher probability of recession.
Five-year breakeven inflation in the United States currently sits at around 2.5%. This means that inflation needs to average 2.5% per annum for investors to “break even” or earn the same when buying a five-year US linker relative to a five-year US Treasury. Our view is this represents reasonable value and we are allocating to the PIMCO Global Low Duration Real Return and L&G Global Index-Linked Bond Index funds.
Mark Preskett is assenior portfolio manager at Morningstar Investment Management