Multi-asset: why your bonds may finally excel in your portfolio

The bond market is a crucial component of the global financial system, influencing everything from mortgage rates to corporate borrowing costs.

But in recent years, a massive component of this market – developed market government bonds – hasn’t been a great investment for people who buy and hold them within a portfolio.

It’s worth remembering that while bonds suffer in times of rising interest rates, interest-rate risk – or longer-dated government bonds – performs well during periods of slower growth and weaker inflation.

That’s why we need to look at what bond yields show us, how the risk versus reward balance has shifted and the implications for debt in a 'soft landing' for the economy.

What the yield curve tells us

One of the most important tools for understanding the bond market is the bond yield curve – a graphical representation of the interest rates for bonds of different maturities.

Typically, the yield curve slopes upward, indicating that longer-term bonds have higher yields than bonds with shorter maturities. This upward slope reflects the higher risk and uncertainty associated with longer-term investments. Investors demand higher yields to compensate for these risks.

However, an inverted yield curve – one in which short-term yields are higher than long-term yields – has been the trend for some 24 months. Under normal circumstances, an inverted yield curve is seen as a predictor of economic recession.

Is this time different?

After some two years of yield-curve inversion, and no recession in sight, many investors have been asking what happened and why the recession predictor hasn’t done its job so far.

There are many reasons, but one of the most important is that recessions typically do not occur when central banks, such as the Federal Reserve (Fed), are tightening monetary policy, or when the yield curve is inverted.

Recessions happen much later. It is often only once the central bank has stopped raising interest rates, and has started cutting them, that a recession begins. That’s also when we stop seeing the inversion in the bond yield curve.

Recession or no recession?

In recent months, investor concerns have shifted from inflation to the risks associated with slower growth. In financial jargon, a ‘hard landing’ has replaced ‘no landing’ as the key investment risk.

There are certainly recessionary signs. For example, economic growth is slowing in many developed countries; in the US, unemployment numbers are also rising.

That said, rising US unemployment is partly driven by growing labour supply from immigration and higher workforce participation, as opposed to companies cutting staff.

Meanwhile, US corporate profitability is still robust, mortgage delinquencies are low, and measures of household net worth are close to record highs.

That’s why our economists believe, for now, that the US economy will manage to escape recession and achieve an elusive ‘soft landing’ – with inflation back in check without the need for a painful economic contraction.

What a ‘soft landing’ means for bonds

Inflation has fallen back to levels that the Fed is comfortable with. The Fed cut interest rates by half a percentage point last month – its first cut of many. The subsequent fall in short-term yields ended some two years of yield-curve inversion.

Meanwhile, inflation has been falling elsewhere and this allowed central banks around the world to shift into rate-cutting mode even earlier than the Fed – although the pace of monetary easing will be dictated by individual circumstances.

We think the risk-reward balance has shifted back in favour of bonds. In a ‘soft landing’ scenario, the safest of fixed-income assets are likely to maintain their value.

But if our economists are wrong, and the US economy does slip into recession, then investors can expect a substantial increase in the value of their holdings in developed market government bonds.

Bonds help diversify risk again

Bonds have traditionally played an important role in helping to diversify risk. Fixed income tends to be negatively correlated with equities – when one falls, the other rises, and vice versa.

That relationship broke down in 2022 when the shock of sustained interest-rate hikes caused both asset classes to collapse at the same time.

That said, the negative correlation dynamic is back and performing its role as a portfolio diversifier. In a falling interest-rate environment, and as investor focus turns once again to growth expectations, slower growth means lower equity and higher bond prices; stronger growth means rising equities and falling bonds.

This is one of those rare instances in which being ‘negative’ can clearly be a positive within the bigger picture.

Final thoughts

Expectations of a ‘soft landing’ in the US, the end of yield-curve inversion and the return of the traditional negative correlation between bonds and equities, make fixed income impossible to ignore.

Developed market government bonds have served a critical role as the world’s haven asset. However, we seem to have forgotten this key investment tenet following years of low yields which made them less attractive to many investors.

As financials markets look ahead to a period of falling interest rates, investors are reminded once again that there are no ‘bad’ asset classes – only bad times to hold them. As equity prices continue to break records, ignore bonds at your peril.

Max Macmillan is head of macro investments - multi-asset asset allocation and research at abrdn.

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