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The True Role of Bonds

For government bonds, they may not offer much by way of attack, but have had an ability to hold up defensively when called upon

Fixed-income markets have enjoyed one of the greatest 30-to 40-year bull markets in history. With 10-year government bond yields falling from highs of over 15% in the early 1980s to lows of 2% today, the asset class has delivered unprecedented outcomes for cautiously-minded investors on a risk-adjusted basis. In many ways, fixed income has been akin to the world’s greatest defence in a football team, with an ability to score goals (deliver returns) and never concede (rarely suffering downside risk). At this juncture, it is therefore healthy to remind ourselves of the two key roles lower-risk bonds play in a portfolio: 1) as a source of return, and 2) to diversify equity risk. We explore these two key roles in detail, showing the implications as we consider fixed income exposure in the current context.

Fixed income as a source of return

When comprehending the opportunity presented by fixed income at current levels, we advocate that investors focus on what is knowable and draw lessons from history. In this regard, we know from broad perspective that the landscape is markedly different –leading to a situation where lower returns are expected and the sensitivity to interest rates is higher.

The lower return expectations tie in to valuations. With low bond yields, valuations are generally considered at the outer bounds of normality. The prognosis from such a position is one of two viable scenarios. First, valuations could remain at the outer bounds of normality, where yields remain low. In this case, major declines from bond markets are unlikely, although the return backdrop is likely to be lower due to the compressed starting yield. The alternative would be for valuations to revert, where we would likely see negative returns followed by something closer to normality. The greater sensitivity to interest rates is a result of duration. As inflation pressures have subsided, governments have been incentivised to lock in low rates for longer periods of time. This phenomenon is far more prevalent in some markets than others, but the basic premise has been lower rates locked in for longer.

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