Bonds blew a big hole in portfolios in 2022 but the reset has left the asset class poised to reclaim its diversifier reputation and deliver decent long-term returns, according to a new Wellington Management paper.
Investor faith in fixed income was tested last year as the sector sank about 13 per cent in tandem with a 20 per cent fall for global shares, which the report diagnoses as a historical “anomaly”.
“We believe last year’s interest-rate moves and asset-price declines have spawned a potentially compelling investment opportunity set for risk-conscious fixed income market participants,” the Wellington study says. “The early 2023 market rally notwithstanding, we expect multiple good price entry points (along with some volatility) to show up over the rest of the year.”
The report authors, including Wellington fixed income strategist, Amar Reganti, suggest that the “cornerstone asset class” will return to its support role as portfolio ballast despite slipping anchor in 2022.
“But it’s important to remember that fixed income investors may stand to benefit from prevailing higher yields over multiyear time horizons,” the paper says. “While the recent sharp increase in bond yields has been painful for many investors in the short term, we believe it can ultimately serve to enhance fixed income’s longer-term income generation and total-return prospects.”
Caution, however, is advised with Wellington favouring high-grade bonds and ‘judicious’ exposure to credit ahead of anticipated volatility and bouts of spread-widening.
Reganti et al also argue against giving in to the no-duration and low credit risk charms of fixed-rate deposits that suffer from reinvestment risk “relative to the opportunity to effectively lock in more lucrative yields for at least the ensuing several years”. “The increasing likelihood of a global recession in 2023 could also supply a catalyst for less restrictive monetary policies and lower longer-term bond yields under a ‘flight-to-quality’ scenario,” the paper says.
Futhermore, the Wellington report suggests three bond strategies offering different risk-return profiles, covering:
- Risk mitigation and diversification – or a core allocation to sovereign and high-grade corporate bonds, possibly tweaked with “flexible, nimble” plays to take advantage of country-specific risks or market volatility;
- Core-plus for the “more risk-tolerant investor” targeting assets such as emerging market debt or other higher-yield sectors via dynamic methods; and,
- Low beta approaches that “pair a core bond portfolio with a credit strategy” to garner uncorrelated returns through all market conditions.