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Bonds are Back

Following a global wave of inflation and the steepest rate hiking cycle in memory, global bond yields are at levels not seen since before the Global Financial Crisis of 2007.

Multi-Strategy
Picture of Nico Nchabeleng

Nico Nchabeleng

Investment Analyst, STANLIB Multi-Strategy

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How bad is the recession going to be? It doesn’t matter. If it’s raining a half an inch an hour, you need an umbrella. If it’s raining two inches an hour, you still need an umbrella. In either case, you need an umbrella.
- DoubleLine Capital founder and CEO Jeffrey Gundlach.

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This is a quote from an interview in February 2023 in which Mr. Gundlach, known as the ‘Bond King’, made the case that investors are going to need some protection in their portfolios irrespective of the intensity of the next recession.

 

In this article, we examine the benefits of using high-quality offshore bonds as an ‘umbrella’ to keep their portfolios dry in the coming rainstorm.

Overview

Following a global wave of inflation and the steepest rate hiking cycle in memory, global bond yields are at levels not seen since before the Global Financial Crisis of 2007.

 

Headline inflation has now rolled over, and markets are expecting central banks to stop hiking rates: we think this is the time to increase allocations to fixed income. Furthermore the prospect of a recession makes bonds a must-have for any portfolio based on what they offer: income, prospective capital gains as markets price in a slowing economy and diversification.

 

South African Balanced Funds have traditionally been underweight global bonds; we think they should be tactically overweight now. By hedging the currency exposure, an SA investor invested in global bonds can achieve significant diversification benefits without being swamped with ZAR currency risk.  

Investment case for global bonds

2022 – A tough year for bonds

Bonds are usually considered boring, safe and a good hedge in equity bear markets; none of these proved true in 2022 as central banks, surprised by the wave of inflation, raised rates at the fastest pace in recent memory.


The yield on the US 10-Year Treasury bond, considered the global benchmark, rose from 1.50% at the beginning of 2022 to a high of around 4.30% in October 2022, creating a total return loss of around 16%.   In fact 2022 was the worst year for US bond investors ever recorded, according to Edward McQuarrie, an investment historian. ‘Even if you go back 250 years, you can’t find a worse year than 2022’, he said (see Table1).


What also made the year unique was the negative annual performance for both bonds and equities.

Why are bonds attractive now?

I) High income generation

Bonds are offering investors historically high levels of income now. Yield-to-worst* on the Bloomberg Global Aggregate Bond Index (Global Agg) is at 3.8% in USD, the highest level since the late 2000s. As inflation rates fall (our economist view) real yields will increase improving the attractiveness of high quality debt.

 

The Fed is forecasting a further 0.5% of hikes in this cycle, so the end of the tightening cycle is in sight.

Admittedly yields were higher in March 2023, but our team felt it was premature to call the bottom for global bonds. At that time the market was predicting that rates would start falling in the second half of 2023; we felt this was too optimistic and have subsequently been vindicated. Those rate cut expectations have largely been priced out of the market.

 

*’Yield to worst’ (YTW) is the term used to describe the lowest possible return that an investor can achieve from holding a particular bond (assuming no default). Some bonds give the issuer the right to repay (‘call’) them at some point before maturity; YTW describes the return that the investor would achieve if the bond is called at the earliest possible moment. YTW is therefore lower than yield to maturity. Callability is a valuable feature for issuers; if interest rates fall during the life of the bond the issuer can call it using the proceeds of another bond issued at a lower yield.

II) Diversification benefit

 

It is our mantra that “all assets are risky assets”. The common view of bonds as boring diversifiers of equity risk is simplistic: bonds aren’t always a diversifier, and their correlation to equity markets and other assets varies through time and under different macro regimes; the positive correlation in 2022 was largely driven by high inflation expectations. Historically, though, bonds are usually a good hedge of equity risk in recessions.

 

 

The longer-term rolling correlation between the two asset classes has peaked, and we anticipate it will mean-revert to lower levels. The short-term rolling correlation between the two asset classes has been negative this year.

 

In almost each of our four 12 months tactical scenarios, we expect bonds to play their defensive role as a diversifier.

III) The potential for capital gains

 

US Treasury yields (prices) tend to move lower (higher) during recessionary periods. Historically, 6- and 12-month forward returns have been positive for bonds when the Fed pivots or pauses during a hiking cycle.

 

But even if we don’t go through a recession but inflation continues to decline from elevated levels bonds offer decent nominal and real returns at levels not seen for some time.

 

Finally, the US 10-year is trading marginally cheaper versus our fair-value; this sort of cheapness protects the portfolio even if our macro or market views don’t play out.

 

One of the consequences of last year’s unprecedented rate tightening is deeply inverted yield curves, meaning that shorter-term bonds have higher yields than longer-term bonds, in developed markets (see Figure 3).

Since 1969, every recession (shaded area in the graph) in the US has been preceded by an inverted curve, suggesting that investors should be reaching for their umbrellas right now. 

 

Nevertheless we acknowledge that there are scenarios in which bond yields would move higher over the short-term:

 

  • Inflation remains elevated: the Fed is forced to extend its hiking cycle. Or if Central banks reduce the need for inflation targeting and allow inflation to settle at higher levels than traditionally targeted.
  • Inflation expectations remain volatile: bond investors require a higher inflation risk premium for holding longer-dated paper.
  • Term-premium (the extra yield demanded by investors to hold long-term bonds over short-term bonds) rises on the back of:
    • deteriorating balance of supply and demand for long term bonds: Quantitative Tightening means less demand and widening budget deficits means more supply and
    • expectation of higher future short-term interest rates (Fed staying higher for longer).

This list of risks is not exhaustive, and different areas of the curve will be impacted differently; such shifts in term-structure (i.e. changes in the shape of the yield curve) also present opportunities.

Global Bonds in a Local Portfolio

Brief backgound

In this section, ‘global bonds’ should be understood to mean global high-quality bonds (ie bonds issued by governments and high-quality corporates).

 

In this article our colleague David McNay showed that SA investors holding global bonds without hedging the currency risk have historically achieved returns similar to those of South African Government Bonds (SAGBs) but with equity-like volatility due to the movement of the Rand.  

 

Hedging the currency materially improves the risk-adjusted returns of global bonds by increasing the return on global bonds (more on this below) while reducing the volatility contributed by the notoriously volatile Rand, referred to by FX traders as the ‘Rattle Snake’.

 

Quantitative Easing and very low inflation expectations led to a decade and a half of ultra-low bond yields in developed markets. Some countries even had negative bond yields even at the long end of the curve, where convexity lives. Low-yielding global bonds struggled to compete for an allocation in SA Balanced Fund portfolios against higher-yielding SAGBs and offshore equities.

FX Hedging

For SA investors considering their offshore allocations, currency hedging is much more important for bonds than it is for equities. Our rule of thumb is that the greater an investor’s tolerance of volatility the less they should hedge the currency risk.

 

Our Multi-Strategy team usually deploys a dynamic hedging strategy, the detail of which is beyond the scope of this article, as opposed to a more passive strategy like selling USDZAR forwards or risk-reversals.

 

For simplicity, though, let’s assume that a South African investor buys US Treasuries and hedges the currency with a 1-year USDZAR Forward.  In order for the market to be efficient (ie to eliminate profitable but riskless trading strategies), an investor in a low interest rate regime hedging investments in a higher rate currency must pay the interest rate differential for the privilege of being hedged.  Conversely, the investor on the other side of the trade (ie in the higher rate currency) will receive the interest rate differential (the ‘carry’), so our SA investor owning US Treasuries will be paid to take the currency hedge [see our paper cited above for more details].

 

Today the carry on the 1-Year USDZAR Forward is 3.6% so our SA an investor can effectively convert global bonds into a ZAR fixed income asset that is decorrelated to other asset classes but with a starting yield of 7.8%. While this starting Rand yield is currently dominated by ZAR-cash from a return perspective, it ignores capital gains potential. If global yields fall by 30bps or more, the investor will make a double-digit return in Rands.

 

 

Even better, volatility on global bonds in ZAR is almost half that of SAGBs, further increasing their appeal as a diversifying asset.

Conclusion

We are positive on global bonds because they offer:

 

1.      High income at the highest credit quality.

2.      Diversification benefit.

3.      Capital gains potential.

 

We have therefore moved to an overweight position in global bonds on a tactical horizon in our portfolios.

 

The high starting yield of sovereign bonds also means an investor does not need to move down the credit curve to eke out some yield.

 

While we recommended currency hedging most of the global bond exposure, an investor can ‘lose out’ on the unhedged portion of the position if the Rand weakens. Our team’s dynamic currency hedging approach helps manage the path dependency and should (and has historically in the 10 years we have been deploying these strategies), outperform a passive strategy in a Rand bull/bear market.

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