Why Government Bonds remain a natural choice

As we approach the eagerly anticipated end of the rate hiking cycle, investors are considering how to position portfolios for what comes next, while trying to navigate the current higher rate, higher inflation environment.

Perhaps now, more than in any other cycle, the role of bonds in portfolios is being questioned after negative annual returns were experienced in 2022.

In this article, we discuss why 2022 was such a difficult year for investors across the board, why higher rates aren’t necessarily a bad thing for active bond investors and why the valuable role bonds play in a diversified investment portfolio hasn’t changed.

2022 an exception rather than the rule

When it comes to making the case for bonds, perhaps the biggest objection comes from those who saw 2022 as a serious flaw in the argument.

Bonds traditionally play the role of what many refer to as ‘portfolio insurance’ – offsetting equities’ losses during market upheaval – but in 2022 they failed to perform this function.

‍So, what happened?

Bond returns have two main enemies, inflation, which erodes their value, and rising interest rates, which reduces the value of existing bonds because higher rates of income are available elsewhere. In 2022, we had both inflation and higher rates in tandem, as central banks aggressively hiked rates in a bid to bring inflation back to tolerable levels.

As active bond investors, we’ve managed portfolios through a number of crises, and to put 2022 in context, this was one of the biggest bond market sell-off events since the great depression.

We see this as an exception to the rule, rather than a ‘new normal’.

While financial market downturns typically see equity markets sell off and bond markets surge, rapid rate rises and inflation result in both asset classes suffering.

The history books are punctuated by market crises, and while history doesn’t repeat, looking to a previous episode of severe negative returns in 1994, interestingly this was followed by a period of outperformance in 1995.

2023 hasn’t been a turnaround year like 1995 was, but we remain of the view that ‘boring bonds’ can quickly turn around in a correction event and that timing the market is impossible. The old adage of ‘time in the market, not timing the market’ holds true in bonds also.

Chart 1: Australian Government Bond Market and Equity Market Annual Returns since 1993
‍Vertical axis Bond Market Returns, horizontal axis Australian Equity Market Returns

Source: Bloomberg AusBond Treasury 0+ Yr Index vs S&P ASX 200 Accumulation Index. As at 27 November 2023.

Higher rates aren't all bad

Increasing interest rates in the context of an actively managed bond portfolio invested over the medium to long term is not necessarily bad. Higher rates restore their value and defensive properties relative to equities and active management enables bonds to be traded on the secondary market, before they mature, meaning that the negative effects of rising rates can be managed.

In the post GFC period of ultra-low interest rates and bond yields, the ability of bonds to deliver meaningful returns and their defensive characteristics were much more limited than they are today in a higher interest rate regime.

In essence, the cushions have now been re-inflated and bonds are now in better shape than they have been for years. If anything, the case for holding bonds has strengthened, particularly if rates have risen too high, too quickly and an economic downturn looks imminent.

A tried and trusted diversifier

Regardless of the path ahead for cash rates, bonds remain a vital diversifier.

Whichever way an investor constructs a portfolio, a diversified range of return sources across asset classes can help mitigate risk.

The top left quadrant of the chart above illustrates events where bonds have provided positive returns, during crises where equity markets were strongly negative. This shows the value of diversification and the traditional portfolio defence role of government bonds in action.

Conclusion

Looking ahead, we believe the delayed impact of the rapid rise in interest rates on the economy could result in an economic downturn, with central banks cutting interest rates well into 2024 to stimulate economies.

In that scenario, allocations to government bonds are typically sort after, driving bond prices and returns higher. About once every decade bond investors are rewarded for their patience and time in the market and we believe that the cyclical nature of the economy, and our analysis suggests that this time is coming.

‍

Want to learn more?

Find out more about government bonds