For many investors, bonds are a substantial part of their allocation. They are seen as a stable asset class, offering some balance with other assets and reduced volatility – generally not meant to be the “exciting” part of the portfolio.
Most Balanced Managed funds here in Ireland have an allocation to fixed income. I looked at 5 of the largest fund managers in Ireland and their allocation to bonds in a balanced managed fund was as follows:
| 20% | 29% | 23% | 25% | 20% |
So bond markets matter.
In the early part of this year, some analysts, after a period of underperformance, felt we were facing a “reset” to a more positive outlook for bonds. Many fund managers spoke of a “pivot” into bonds on the basis that we were facing into a global reduction in interest rates.
We still are – kind of.
Interest rates have been reduced and likely to fall further. But the question becomes where will they end up? Maybe higher than some had thought.
In the US a likely boost to inflation from Trump policies is probably going to slow the pace of rate cuts and the terminal rate that the US central bank ends up with, may be higher than analysts had previously thought. Markets currently think US interest rates could get down to just over 3.5%. A month ago the forecast was for a bottom rate closer to 3%.
When we add in the prospect of Trump trying to have a role in interest rate decisions, bond investors may look for some risk premium in yields.
The mood music may have changed elsewhere as well. In the UK, even as they cut rates, the Bank of England suggested that a more gradual approach to lowering rates might be needed in the future. Their chief economist also noted that geo-political risks could affect the path of rate cuts.
As for Europe, while the underlying economy needs lower rates, our own Central Bank governor Gabriel Makhlouf pointed out that monetary policy is not a sprint and that we needed to “pace” ourselves.
Recently it’s been a tough period for bond investors. We have seen more volatile moves in bond yields especially since September. In fact measures of bond volatility such as the MOVE index pushed up to new heights from the summer into early November. And in that period we have seen weaker government bond markets. Bond yields have spiked up (prices have fallen), even as interest rates were being cut. In the US for example, the yield on the 10 year treasury bond went from 3.65% in September to around the 4.3% level now. We saw similar moves in Europe and the UK.
At time of writing, government bond returns so far this year here in Europe have been broadly flat. Most Irish funds that invest in government bonds are showing no return over the past 6 months. And now some strategists in the past week, in the face of perhaps shallower or slower rate cuts, have talked of the 10 year US bond yield moving up from current levels towards 5%!
Apart from this more cautious view on the rate cycle, bond investors also have to contend with the fact there will be no shortage of bond issues in major economies such as the US, UK and Europe. Goldman Sachs estimate bond supply in Europe to reach almost €1tn. next year, as the ECB’s quantitative tightening picks up speed.
Bond managers (and investors) have many levers to pull – government or corporate, investment grade or high yield, long or short duration. Navigating through the bond landscape we now face will likely require all the available levers be used.
Tradewinds 