Defence: key to successful portfolios

19 May 2023

Bonds can offer protection again

Bonds have traditionally had an important role in portfolios, both as a source of income and as an offset to recession or equity risk. Bonds struggled to perform these roles in 2022, hampered by the combination of high inflation and very low starting yields. However, with yields reset at higher levels, bonds have the potential to fulfill their traditional roles once again.

We believe, with much higher yields amid increased general market volatility, bonds are offering an attractive investment proposition both as a recession and equity risk hedge as well as a relatively stable source of attractive total returns for a broader investment portfolio.

Historically, bonds have performed well heading into recessions, especially relative to the highly volatile experience in equity markets - as investors flee the uncertainty of stocks to the relative safety of fixed coupons. Below shows the experience of the Bloomberg US Aggregate (a broad benchmark containing governments, corporates and securitized issuers) around US recessions, highlighting the historical consistency of bond returns, performing strongly heading into and during recessions.

Chart 1: Past performance of bonds leading into and during a recession

Source: Bloomberg.

That consistency also extends to more common periods of equity weakness - whether that coincides with an actual recession or not. As shown in Chart 2, Apart from 2022, US bonds have generated positive returns in all of the largest US equity drawdowns in the last 30 years – highlighting both the potential value to a diversified portfolio, as well as the challenges high quality bonds (such as government and investment grade credit) faced in 2022, coming out of an environment of historically low yields.

Chart 2: Bonds have historically provided a strong offset to equity drawdowns

Source: Bloomberg. US Equities is the S&P500. US bonds is the US Treasury index.

Not all yield is created equal

Seeking protection via cash was an appropriate strategy in 2022, with most bond and equity markets significantly underperforming. As central banks have increased rates, the yields on cash and similar investments have also risen sharply, leading to a temptation from investors to continue to seek shelter in this asset class. But there is eventually a cost to being too defensive: periods of high cash yields (such as now) have historically signalled an attractive time to exit cash and own more long duration bonds, not less.

Why is that, despite very similar starting yields? A bond investor is effectively locking in a given yield for the life of the bond: 7-10 years on average for a representative bond benchmark. Cash investors on the other hand, may lock in a rate for 3 months, or maybe a year, but then face re-investment risk at maturity. The value of buying a longer-term yield becomes meaningful when rates fall – as has historically happened when hiking cycles end in overtightening: yields fall, cash investors lose out, but bond investors have locked in their higher yields.

Chart 3: Bonds have historically performed better than cash following a peak in rates

Source: Bloomberg.

Chart 3 shows the yield on the US Treasury index, as well as the yield on a 3-month US government T-Bill: a proxy for very short term high quality cash yields. The chart demonstrates the current temptation: that is, to own cash instead of bonds, and still earn a similar short-term yield. However, historical experience has shown during these periods bonds have generated a considerably stronger outcome for investors versus cash.

Ultimately, history has shown that fixed income plays a key role in a diversified portfolio and has long offered defensive benefits against equity and recession risk. For investors concerned with the impact of recession risk or downside equity risk on portfolios, an allocation to more defensive assets, such as bonds, can help to protect portfolios. Bonds generally exhibit a lower risk, or variation in returns, and over the long term are negatively correlated to equity returns, with the ability to provide a buffer to a diversified portfolio during times of stress. As such, with much higher yields amid increased general market volatility, we believe bonds are offering an attractive investment proposition both as a recession and equity risk hedge as well as a relatively stable source of attractive total returns for a broader investment portfolio.