MyFolio: why higher bond yields could turn from headwinds to tailwinds

In our latest MyFolio webinar, Chief Economist Paul Diggle and Katie Trowsdale from the MyFolio team looked back at the third quarter and set out what may lie ahead for multi-asset investors.

The presenters noted that rising bond yields weighed on MyFolio returns in the period. However, the MyFolio team sees an improved long-term outlook for bonds.
In the UK, 10-year gilt yields rose from just under 4.8% to around 5.4% over the quarter (1). Thirty-year gilt yields reached 5.8%, their highest level this millennium (2). In the US, 10-year Treasury yields rose from around 4.4% to above 5% (1). Both markets hit their highest 10-year yields since 2007. Japan's 10-year yield went above 3% for the first time since 1996, after years at or below zero (1).

Why yields have risen

Paul sees two main reasons for rising yields. The first is interest rate expectations. The energy shock has kept inflation sticky, and economic growth has held up better than expected. Investors now expect central banks to raise rates further. 

The second is the term premium. This is the extra return investors demand for holding longer-dated bonds. Investors have been worried about the size of government debt and whether bonds can help preserve capital if equities fall.

Why have UK gilt yields been hit so hard?

Several European countries face similar fiscal and political pressures. So why have gilt yields been hit so hard? Paul points to three UK-specific factors. 

First, the gilt market has lost a large captive buyer, as UK pension schemes now buy fewer long-dated gilts through liability-driven investment (LDI) strategies. Second, the Bank of England has been one of the few central banks actively selling its bond holdings. Third, the UK Budget is a large set-piece event that attracts heavy speculation. We estimate that increased interest payments due to higher gilt yields have more than halved the government's fiscal headroom of roughly £24 billion (3).

Some of these pressures may now be easing. The Bank of England is changing its approach to selling gilts, and UK growth has been strong this year compared with other G7 economies. 

Bonds are no longer a simple safety net

For most of the period since the late 1990s, bonds and equities tended to move in opposite directions. When shares fell, bonds usually softened the blow. The year 2022 showed that this relationship does not always hold, and the third quarter was another reminder. As yields rose, bonds fell, and much of the equity market fell with them.

Katie said the MyFolio team takes this change into account when building portfolios. Short-dated bonds are less sensitive to interest rate changes, and they held up well. Short-dated sterling corporate bonds fell by less than 0.5%. By comparison, global government bonds fell by 2.6% and global corporate bonds by more than 3% (4). In the active MyFolio ranges, diversified defensive funds delivered positive returns over the quarter.  Within the MyFolio range of Funds short-dated bond exposure now represents a third of our total having increased their allocation in the last strategic asset allocation review.

Signs that fixed income value is returning 

Here are three reasons we believe the global bond market offers opportunity:

1) Bond markets may have overshot. Investors are pricing in more rate rises from the Bank of England, the European Central Bank and the Federal Reserve than our economists expect. We see current rate rises as a mid-cycle adjustment, not the start of a sustained hiking cycle.

2) Real yields look more attractive. At nearly 3%, the US 10-year real yield is compelling (5). A real yield is the return above inflation. 

3) There are even early signs that the old bond/equity relationship is returning. When technology and semiconductor stocks fell recently, bond markets rallied. That suggests fixed income can still potentially offer a degree of protection against the biggest risk to equities: a sharp reversal in the AI trade. A mandate to choose from a broad range of credit qualities, regions and maturities can help investors to further boost diversification.

Weighing these factors, we think the outlook for fixed income has improved while equity prospects have weakened following a strong run.

What could go wrong?

Of course, there are still risks. Our central macro forecast includes an unusually wide range of possible scenarios, from a 55% baseline of ‘Resilience Despite the Risks’ to downsides of ‘New World Disorder’ (25%) and or ‘Bond Market Rout’ (15%).

Our analysis suggests that US 10-year yields above 5.2% are a drag on equities, and yields have already moved above that level (6).

Final thoughts...

Higher bond yields were a headwind in the third quarter, weighing on returns. But they also mean investors now start from a higher level of income. Add rate expectations that may have overshot, and early signs that bonds can diversify again, and that recent headwind could become a tailwind for risk-managed multi-asset portfolios going forward. Risks remain, not least with US 10-year yields beyond 5.2%, but the balance has shifted towards a more positive view on fixed income.

For the latest updates on the MyFolio risk-targeted fund range, listen on-demand to our MyFolio Q3 Webinar.

For more information on MyFolio visit our website, or for details about Aberdeen MPS ranges click here. 
 

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