Are bonds now a buying opportunity?

Over the past two years, the bond market has experienced high levels of uncertainty and volatility. As a consequence, risk-based strategies have been underweight the asset class. However, in the current environment, bond carry has been rising amid a disinflationary trend.  In this weekly edition of Simply put, we look at whether bonds are truly back.

 

Need to know: Improving prospects for bonds may encourage investors to increase fixed-income allocations Our multi-asset strategy is still underweight bonds, despite increasing yields Carry returns are likely to be more attractive as they will dominate volatility over longer holding periods

 

Evolution of our bond exposure

Carry is becoming more attractive, but in our view this is being offset by an increase in volatility. However, the decline in duration as yields rise and issued maturities shorten could temper the increase in yield volatility. Against this backdrop, we have only slightly increased the bond exposure of our risk-based strategy, All Roads.

Why such a marginal increase? Are we blind to the appeal of higher carry?

The evolution of our multi-asset strategy’s allocation to bonds is shown in figure 1. Over the long run, the portfolio holds more than 50% bonds (typically 10-year instruments). But, as shown below, we have been underweight position in bonds for over a year, hitting a low of 27% in June. Since then, it has increased to 35%.

The main driver of our total bond exposure is explained by our risk-based investment process: as volatility declined, our allocation increased. Macro signals also prompted a marginal increase due to the recently worsening growth data. Our trend-following overlay further reduced the allocation, however, as rates rose. Yet, with higher yields and thus higher carry, some investors would prefer to invest more in long bonds. Why don’t we?

 

FIG 1. Evolution of our multi-asset strategy’s bond allocation

Rebased to 100% of portfolio exposure

Source: Bloomberg, LOIM. For illustrative purposes only. Holdings and/or allocations are subject to change

 

A long-term opportunity

We view long bonds as a potentially attractive opportunity for long-term strategies, with horizons of  3 years or longer, and could again provide an interesting source of diversification. However, the case is not as clear cut for short-term investment horizons of under a year, such as ours.

At present, US 10-year yields stand at around 5% and offer a decent carry, but let’s analyse the associated risks, which are detailed in figure 2. It shows the expected annualised return of a standard aggregated index, surrounded by an interval of confidence, as a function of the holding period. As the holding period lengthens, the probability of negative returns diminishes. To summarise the outcome in one sentence, risk dominates return in the short run, while return dominates risk in the longer run.

We don’t deny that bonds are coming back, and we have recently added to our allocation. But in the near term, we see more potentially attractive opportunities in money markets for our strategy. The prevailing interest rate, currently at 5.5%, presents an appealing opportunity at near-zero volatility, which is good for our risk-based strategy.

 

FIG 2. Annualised carry of the Bloomberg Barclays Aggregate index vs 95% risk intervals for different holding periods

Source: LOIM, Bloomberg. For illustrative purposes only.

 

Simply put, higher carry makes bonds a good opportunity for long-term investors. But those with shorter time horizons, such as ourselves, will likely still prefer cash.

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Nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises, and global monetary policy surprises designed to track the recent progression of macroeconomic factors driving the markets.

Our nowcasters indicators currently show:

• Growth: continued to decline this week. US and Chinese output are now close together
• Inflation: pressures still trended upwards from low levels, but slowed from the recent pace
• Monetary policy surprises: should remain muted, in line with the Federal Reserve’s communication last week.

 

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

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