Ask ii: when will bonds recover and boost my multi-asset portfolios?

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Neil asks: “I've invested in a few multi-asset funds that have a bias towards bonds. They have all suffered from the double whammy of equity and bond market devaluations over the last year.

“At what point will the particular bond-related funds recover their value? Or is it the case that, say, a bond fund focused on 10-year bonds will never really bounce back because of the prevalence of 'historic bonds'?

Sam Benstead, deputy collectives editor, interactive investor, (pictured above) says: Neil will not be alone in being hit by the double whammy of stock and bond losses last year, where the multi-asset funds with the most bonds – which were expected to be the least risky – actually fell more than portfolios just invested in the stock market.

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Bonds are sensitive to interest rates, with higher interest rates causing bonds to fall in value as investors reassess the yield they require to own bonds when central banks put up the risk-free rate.

The good news for Neil is that the damage to bond prices could already be done as inflation seems to be peaking in the US and Britain.

Signs that “core” inflation is easing, which excludes volatile items such as energy and food costs, will let central banks rein in rate hikes and even cut rates next year to support the economy, which would boost bond prices.

Trawling through investment outlooks for 2023, the clear consensus was that bonds now make good investments again, as yields are far higher than a year ago and bonds’ defensive characteristics should come to the fore again if there is an economic slowdown. Professional investors were particularly keen on investment grade and developed government bonds, which carry the least default risk.

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Investors point to current yields – which is what an investor would get paid annually today accounting for the return of their principal when the bond matures – as a reason to own bonds. This is roughly 3.5% to buy UK government debt, or about 5% for a basket of low-risk corporate bonds.

However, Neil correctly points out that his multi-asset portfolios own lower-yielding old bonds. This means that the distribution yield – which is what you get paid in income from bonds – will take some time to catch up with market bond yields today for new buyers.

A portfolio of historic bonds will benefit from lower bond prices however, which is why there has been a recovery in multi-asset portfolios over the past few months as investors have positioned for peak inflation and even interest rate cuts in 2023.

With that in mind, stock and bond portfolios look set to have a better 2023 after a terrible 2022.

Nevertheless, some professional investors think the 60/40 split between stocks and bonds is outdated as we enter a period of structurally higher inflation due to labour shortages, higher wages, and deglobalisation.

One is Dan Brocklebank, of Orbis Investments. The Orbis Global Balanced fund has just 20% in bonds, with much of that in inflation-linked bonds, where the coupon rises with the inflation rate.

He says: “The passive 60/40 portfolio may no longer be a good investment option, as valuation will become much more important in investing now that interest rates have risen. The next 10 years could look very different to the last 10 years as we enter a new investment paradigm of higher inflation and interest rates.

“Inflation is still far higher than bond yields, which makes bonds expensive still. Investors should look to active management to find cheap stocks and bonds for their portfolios, rather than just owning a market-cap weighted index that was successful during a period when interest rates kept falling.”

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BlackRock’s head of portfolio research and UK chief investment strategist Vivek Paul takes a similar view.

Paul says: “During the ‘Great Moderation’, a period characterised by unusually steady growth and inflation, investors could rely on central banks riding to the rescue during growth crises – pushing down yields, and making bonds a fantastic hedge during equity drawdowns.

“This ‘negative correlation’ between bonds and equity was at the cornerstone of why a 60/40 portfolio used to make so much sense. In the new regime characterised by higher volatility, higher inflation and supply constraints, bonds won’t work as well as a portfolio ballast. Portfolios need to be built differently.”