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Bond carnage: Is it time to exit fixed income?

Anthony Fensom  |  06 Apr 2022Text size  Decrease  Increase  |  
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Global bond markets have suffered unprecedented losses since last year’s peak as central banks worldwide tighten monetary policy to combat rising inflation.

The Bloomberg Global Aggregate Index, a benchmark for government and corporate debt, has dived 11% from its January 2021 high. The loss in value is estimated at around US$2.6 trillion (A$3.5 trillion), its worst performance since the US$2 trillion lost in 2008 at the height of the global financial crisis. The AusBond Composite Bond Index lost a record 3.75% in March, its worst monthly return in 33 years.

The selloff is returning large chunks of the bond market to positive yield for the first time in years. From a peak of US$18 trillion in December 2020, negative yielding bonds fell to just $2 trillion this March. 

The turnaround has Bank of America strategists declaring a ‘third bond bear market’, with the return on US government bonds expected to post its worst year since 1949. Previous bond bear markets ran from 1899 to 1920 and from 1946 to 1981, the US bank says.

From a previous bull market, the switch now is from “deflation to inflation, globalisation to isolationism, monetary to fiscal excess, capitalism to populism, inequality to inclusion, US dollar debasement,” according to Michael Hartnett, chief investment strategist at Bank of America.

Hartnett predicts long-term US bond yields will exceed 4% by 2024, which compares to their low of 0.5% reached in 2020.

Bond yields are soaring as investors ditch debt. The yield on benchmark US 10-year government bonds has soared to around 2.5%, up from 1.5% at the start of the year. The 10-year government bond yield climbed to 2.9% last month, compared to just 1.1% in August 2021. Yields rise as prices fall.

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Central banks tighten the noose

Bond market turmoil comes alongside March’s 25 basis point (0.25%) rate hike by the US Federal Reserve, its first such move since 2018. Markets have priced in the equivalent of nine more quarter-point hikes by the end of 2022.

Economists at ANZ see the Reserve Bank of Australia (RBA) making its first move in June, following the April release of data on wages and inflation.

“When the RBA starts to hike, we expect it to move with some vigour and the cash rate to reach 2 per cent by the end of 2023,” the bank said in a March 29 report.

Capital Economics also expects the RBA to start hiking in June on the back of rising inflation.

Fixed income as ballast

Asked how fixed income investors should respond, John Likos, direct of data and research firm BondAdvisor, stresses the importance of protecting capital.

“Capital preservation is key in this market,” he says. “There’s clearly a lot happening – you’ve got geopolitical risks, you’re seeing higher inflation through rising commodity prices, and you’re got policy risks, such as not hiking aggressively enough or hiking too aggressively.”

“In an inflationary environment, we’re buying higher quality and floating rate exposures, as these benefit from rising benchmark [BBSW] rates.

“It’s also important to keep some cash on the side for optionality – you’re not going to be getting crazy returns like we have in the past few years, but we don’t think this is a time to be chasing those kinds of returns.”

Nevertheless, Likos and other bond investors argue fixed income has a place in a balanced portfolio, describing it as a “ballast”.

He noted that when share prices dived by around 34% during the GFC, the market for investment-grade bonds returned more than 8%. During the first quarter of 2020 when the COVID-19 pandemic hit markets, bonds returned around 1% while equities dropped by almost 16%.

“Such uncorrelated returns demonstrate the diversification benefits that a balanced portfolio of stocks and bonds offers investors,” he added.

Likos says bond market warnings of a potential recession in the United States show the importance of keeping an exposure to fixed income.

“If central banks suddenly turn around and start cutting rates again in a few years’ time, bonds will outperform again,” he says. “Because you don’t know what central banks are going to do, you’ve always got to have some exposure – you don’t want to get in after the fact.”

is a Morningstar contributor.

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