The yield these bonds offered at the start of 2023 was much higher than in 2022, so the “carry” (ongoing interest received) investors are earning for holding these bonds is much higher and helps compensate them for the risk that yields move higher.
Also, while interest rate expectations have moved significantly higher this year, the relative increases are far below those of 2022.
Central bank watching is key
So what should be considered when thinking about bond allocations today? I think central banks are the first port of call, and intrinsically linked to them is inflation.
It is well documented that government bond curves are inverted, particularly the US one, given the historical accuracy with which an inversion of the three-month/10-year pair has preceded a recession. With long-dated bonds earning less than short-term counterparts, you are being paid less for greater duration you take on.
However, the flip side is that, as we covered earlier, duration amplifies the returns from yield moves. So if bond yields fall you are clearly better off being in longer-dated bonds despite the lower yields.
Historically, big declines in long-dated gilt yields before the last central bank rate hike are rare. Therefore, you need to consider whether you expect economic data to remain robust for some time. If so, you should prefer to keep duration short.
But if you think we are approaching a downturn and the end of the hiking cycle, it makes sense to start extending duration. Another factor —particularly when considering the duration of government bond positions — is that conditions appear to be in place for the correlation between the returns of government bonds and equities to turn negative again, following a couple of years in which it has generally been positive.
Government bonds may soon start to provide protection against weakness in equity markets again, as they have done for most of the 2000s. Equity-bond correlation has nearly always been positive when inflation is more than about 5 per cent to 6 per cent – only when inflation is lower than that does the correlation potentially turn negative historically.
Headline inflation is already below 5 per cent in the US and should get there soon in the UK.
Allocating to credit?
You need to decide if you wish to allocate to credit, and if so where on the risk spectrum. As was covered earlier, high-yield bonds generally have lower duration than their investment-grade counterparts.
