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Time to (re)consider bonds
Peter Siks
Summary: The tide has turned for bonds. Given the current yields, bonds have become an attractive investment, with added benefits including lower risk than stocks, increased diversification and a steady stream of income unaffected by economic changes.
For a long time, bonds were not the place to be as an investor. During the ultra-low interest rate period, bond yields were exceptionally low. But the tide has changed dramatically in the last two years. The yield on the 10-year bond of Germany has climbed from below zero in October 2021 to 2.6% at time of writing. In the US, the 10-year yield has climbed from 1.5% to 4.3%.
If we look at the shorter maturities, the changes are even more striking: the yield for 2-year Bills in the US increased from 0.5% to 5% in just two years. In Germany, the 2-year yield has climbed from - 0.5% to 3%.
Looking at the different bond indices, the same pattern is visible. In the graph below, the following 10Y bond yields are displayed:
| Yellow: | US High Yield | 8,5% |
| Red: | EUR High Yield | 8,3% |
| White: | US aggregate | 5,1% |
| Orange: | EUR aggregate | 3,8% |
Why is all this happening?
Due to the higher interest rates by the FED (Federal Reserve Board) and ECB (European Central Bank), the whole interest rate environment changed. From a low yielding asset class, bonds transformed to an interesting opportunity given the current effective yields.
In the two graphs below, you see the interest steps taken by the ECB and FED.
The steps taken by the central banks lifted all interest rates. During ‘the rise of the rates’, bond holders were hurt because the value of their bond holdings (seriously) declined. The year 2022 is recorded to be one of the most negative for bond holders. Also, the year 2023 has not been a successful year for bonds. The total return hovers around 1% - 2%. There are exceptions: high yield bonds have performed quite well; their performance in the US this year has been around 6% - 7%.
Nevertheless, the Saxo Strats believe that most of the interest rate hikes are done, especially in the US. This results in a limited downside risk for the price of bonds, and this makes the current yield attractive. And in the scenario where the rising interest rate flips to declining interest rates, the bond holding will even appreciate in value.
Benefits of adding bonds to the portfolio
There are several benefits of adding bonds to the portfolio.
- Diversification: Bonds tend to perform differently than stocks, so adding bonds to a portfolio can help reduce overall volatility and risk. Bonds can provide stability when stock prices decline.
- Income: Bonds provide regular interest payments that can serve as a source of income for investors. This income can be used to fund living expenses or be reinvested. This is especially attractive for people in retirement.
- Stability: Most bond coupon payments are fixed, so they provide a steady stream of income that is not affected by economic changes. This contrasts with stock dividends, which can vary.
- Lower risk: Bonds are generally less risky than stocks, especially high-quality government bonds, which have minimal default risk. Bonds can help offset the higher risk of equities.
- Principal preservation: Holding bonds to maturity allows investors to recoup their principal investment amount. This provides a safety net against potential stock losses.
In summary, the key benefits of adding bonds to a stock portfolio are increased diversification, stable income, lower portfolio volatility, and principal protection. Bonds can balance out some of the risks associated with equities.
How much to invest in bonds
This depends on the profile of the individual investor. Things to consider are age, investment horizon, risk appetite and investment goals. What can be said though in general is: the older you are, the higher the percentage of bonds will be. This approach can also be recognised by the pension funds. For younger participants, stocks will be overweight whereas, because retirement comes closer, older participants will be overweight bonds. The rule of thumb here could be: invest your age – as a percentage – in bonds. Investors can (and will) deviate from this approach, but the underlying message is clear. The older you get, the more one normally invests in bonds.
Correlation with stocks
Bonds can provide diversification from equities. Bonds often move differently than stocks, so combining the two asset classes can smooth out a portfolio's returns over time. Bonds may rise when stocks fall, helping cushion the impact. In the graph below, you can see how the correlation between global stocks and bonds has been for the last 60 years.
As can be seen in the graph, the correlation between stocks and bonds is changing over time. In the last two decades the correlation has been negative but in three decades before the year 2000, the correlation was positive.
The factors that impact the stock – bond correlation can change over time. To name a few: in uncertain periods, the correlation is negative, due to a flight to safety (investors then favor bonds for stocks). Also, when volatility in the stock market is high, the correlation becomes negative. Inflation though can lead to a positive correlation because inflation will lead to higher interest rates (hurting bonds) and (probably) lower company profits (hurting stocks). Another factor that might result in stocks and bonds moving in the same direction is the rise of the real yields, because it increases the real discount rate. This is negative for both the prices of stocks and bonds.
Below you will find the real interest rates for the US for the last 40 years.
Wrap up
So, in summary, given the current yields, bonds are an attractive investment opportunity. There is the risk of further rate hikes by the central banks worldwide if inflation is not contained, but we do not see that as our base case scenario. The Saxo Strats believe that peak rate is close and that the interest rate will decline in 2024. This makes the current yields even more attractive.