08 Mar 2023
Five charts to explain why fixed income deserves its place in a multi-asset portfolio
Following a sharp sell-off in bonds over the course of 2022, this piece uses five charts from the Guide to the Markets to explain why we now see some of the most exciting opportunities in fixed income in over a decade.
Fixed income has historically provided two key characteristics in a multi-asset portfolio:
1) A steady stream of income
2) Diversification against riskier assets if the growth outlook deteriorates
For much of the past decade, the ability of bonds to offer either of these was steadily diminishing. A long bull market compressed yields to record low levels, forcing investors to make an unenviable choice: accept paltry returns by investing in government bonds at ever lower yields, or chase higher yields in lower quality parts of the fixed income universe and take on much more risk as a result?
The declines witnessed in fixed income markets in 2022 were unprecedented. The global aggregate bond index fell by 16%, the worst annual decline since the index began in 1990 and more than three times as bad as the second worst year on record. Yet while last year’s correction was extremely painful, it was also necessary as central banks realised it was no longer appropriate to be running the ultra-loose monetary policies that had prevailed for much of the previous decade. We believe that the fixed income reset is now complete and that the role of bonds in a balanced portfolio has been restored, both in terms of income and diversification against recession risks.
1: Good riddance to negatively yielding debt
Global government bond yields
% of BofA/Merrill Lynch Global Government Bond Index
Source: Bloomberg, BofA/Merrill Lynch, J.P. Morgan Asset Management. Index shown is the BofA/Merrill Lynch Global Government Bond index. Past performance is not a reliable indicator of current and future results. Guide to the Markets - UK. Data as of 31 January 2023.
Our first chart considers the significant changes in the fixed income landscape. Just three years ago, a staggering 90% of the government bond market was offering a yield of less than 1%, and around 40% of the universe was trading at a negative yield.
The sharp move higher in yields over the course of 2022 has seen the stockpile of negatively yielding debt all but disappear, and now less than 20% of this market yields less than 1%. This vastly increases the instruments in a multi-asset toolkit for investors that are looking to build balanced portfolios.
2: Inflation should moderate in 2023
Median of economists’ forecasts for headline CPI
% change year on year, quarterly average
Source: Bloomberg, BLS, Eurostat, ONS, J.P. Morgan Asset Management. CPI is consumer price index. Guide to the Markets - UK. Data as of 31 January 2023.
Surging inflation was at the root of the bond market’s troubles in 2022. When Russia invaded Ukraine, the spike in energy prices forced inflation sharply higher. With Western labour markets already tight, central banks saw a significant risk that a one-time cost shock would become embedded as workers battled for real pay rises. Policymakers had little choice but to lean against the inflationary impulse.
Looking forward, we do not expect 2023 to be a repeat of last year. As the chart shows, inflation is expected to come down across developed economies over the coming quarters as the impulse of food and energy prices fades and the global economy weakens. As a result, we expect central banks in major developed economies to pause their rate hiking cycles in the first half of 2023. This should help to stabilise bond markets. However, investors should remain selective. In the UK, structural labour market shortages are likely to keep inflation higher for longer, putting more pressure on the Bank of England to deliver further rate hikes. We also anticipate an end to the Bank of Japan’s yield curve control policy, which has the potential to generate significant volatility in the Japanese bond market. This highlights the importance of an active approach within a global opportunity set when considering fixed income allocations.
3: Yields have moved higher across the fixed income spectrum
Fixed income yields
Source: Bloomberg, Bloomberg Barclays, ICE BofA, J.P. Morgan Economic Research, Refinitiv Datastream, J.P. Morgan Asset Management. Return correlation to MSCI All-Country World Index is calculated using monthly total returns since 2008. Indices used are as follows: Euro IG: Bloomberg Barclays Euro-Aggregate – Corporate; Global IG: Bloomberg Barclays Global Aggregate – Corporate; UK IG: Bloomberg Barclays Sterling Aggregate – Corporate; US IG: Bloomberg Barclays US Aggregate – Corporate; Convertible bonds: Bloomberg Barclays Global Convertible Rate Sensitive hedged to USD; Euro HY: ICE BofA Euro Developed Markets Non-Financial High Yield Constrained Index; Global HY: ICE BofA Global High Yield Index; US HY: ICE BofA US High Yield Constrained Index; EMD corporate: CEMBI Broad Diversified; EMD local: GBI-EM Global Diversified; EMD local – China: JP Morgan GBI-EM Broad Diversified China; EMD sovereign: EMBI Global Diversified; EMD sov. IG: EMBI Global Diversified IG; EMD sov. HY: EMBI Global Diversified HY. Past performance is not a reliable indicator of current and future results. Guide to the Markets - UK. Data as of 31 January 2023.
Our third chart considers the ‘menu of options’ across the fixed income universe. The bars show yields in January 2023, and the diamonds show where they stood at the start of 2022. As the chart highlights, yields across the fixed income spectrum have moved significantly higher over the past year. This is positive for two key reasons: it improves the income available, and it also creates room for yields to fall again in the event of a shock to the growth outlook. Higher yields are available in riskier categories such as emerging market bonds and high yield corporate bonds, but investors should pay attention to how the correlation to equities increases as you move from left to right on this chart. For diversification against recession risk, government bonds have the biggest role to play given their typically low or negative correlation to stocks.
4: Diversification potential has also improved
Total return scenarios for US Treasuries
Source: Bloomberg, J.P. Morgan Asset Management. Chart indicates the calculated total return achieved by purchasing US 10-year Treasuries at the current yield and selling at the end of 2023 given various changes in yield. For illustrative purposes only. Past performance is not a reliable indicator of current and future results. Guide to the Markets - UK. Data as of 31 December 2022.
In addition to the improvement in income on offer, we believe the ability of bonds to diversify against recession risk – rising in price when equity prices are falling – is now also much stronger. Our fourth chart considers the total return that investors would receive from US Treasuries depending on how yields move in 2023. While it is not our base case, if the global economy did fall into a deep recession in 2023, the markets would likely flip quickly from worrying about inflation to worrying about deflation. In this scenario, bond yields would have significant room to fall from current levels. In the event that 10-year US Treasury yields fell by 200 basis points, this would deliver a return of close to 20%. This is the kind of meaningful diversification against equity losses that multi-asset investors rely on when constructing balanced portfolios, and has not been available for several years given the very low level of yields.
5: Favour higher quality credit over lower quality counterparts
Fixed income spreads
%, option-adjusted spread
Source: Bloomberg, Bloomberg Barclays, ICE BofA, J.P. Morgan Economic Research, Refinitiv Datastream, J.P. Morgan Asset Management. Euro IG: Bloomberg Barclays Euro Agg. – Corporate; US HY: ICE BofA US High Yield Constrained; EM Debt: J.P. Morgan EMBI Global Diversified; Euro HY: ICE BofA Euro Developed Markets Non-Financial High Yield Constrained; US IG: Bloomberg Barclays US Agg. Corporate – Investment Grade; UK IG: Bloomberg Barclays Sterling Agg.– Corporates; UK Gilts: Bloomberg Barclays Sterling Gilts; US Treasuries: Bloomberg Barclays US Agg. Gov. – Treasury; Infl Linked: ICE BofA UK Gilt Inflation-Linked Government. Hypothetical portfolio (for illustrative purposes only and should not be taken as a recommendation): 20% UK Gilts; 15% US Treasuries; 10% Linkers; 15% US IG; 10% UK IG; 10% US HY; 5% Euro HY; 15% EM Debt. Annualised return covers period 2013 to 2022 inclusive. Returns are unhedged in sterling and local currencies. Past performance is not a reliable indicator of current and future results. Guide to the Markets - UK. Data as of 31 December 2022.
Our final chart considers credit spreads, or the extra compensation that investors are paid for investing in corporate bonds over government bonds. Despite the deteriorating economic outlook, corporate fundamentals across the US and Europe remain strong. In recent years we have seen a clear trend of companies reducing their leverage levels and extending the maturity profile of outstanding debt, reducing near-term refinancing needs. These solid fundamentals should limit the amount that spreads widen if we do see a recession this year, although spreads on lower quality, high yield companies would likely move much higher than spreads on higher quality segments in this scenario. As a result, we believe that an “up-in-quality” approach remains prudent in the current environment.
2022 was a historically difficult year for bond investors but the opportunities available in fixed income are the most compelling in over a decade. Whether for income or diversification against recession risk, bonds deserve their place in a balanced portfolio once again, even though an element of selectivity will still be required.
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