5 min read 13 Oct 22
This year’s very high levels of inflation have led to a rise in volatility for bond markets as central banks have tightened policy. Rather than being a one off shock, we think that we are now entering a new era where inflation is no longer benign. For cautious investors holding bonds to mitigate portfolio risk this volatility presents an unwelcome challenge. We believe that multi-asset investors need to broaden their investment universe to mitigate the risks of this environment and to capture the new investment opportunities it brings.
If there is one principle of investment that everyone knows it is that you shouldn’t put all of your eggs into one basket. Far better to diversify your holdings and reduce your overall level of risk. In the modern multi-asset portfolio this principle is often viewed as meaning that the fund’s asset allocation should be split between equity and bonds. The more risk averse or cautious you are, the more you should allocate to bonds. The approach relies on the idea that bonds are “secure” instruments that pay a dependable level of income and therefore have relatively little volatility. As a result when equities sell-off, bonds will, in theory at least, take up the slack and limit portfolio losses.
This relationship has been particularly evident over the past 30-years. During this time the relatively benign inflation backdrop has enabled central banks to have an asymmetric policy approach. That is, they have been cautious when hiking interest rates, but aggressive when cutting.
Over the past 12 months the principles underpinning this thinking have been challenged. Inflation is no longer benign, but is at multi-decade highs and sticky. In response central banks have sought to get ahead of the curve and have hiked interest rates aggressively. The US Federal Reserve for example has been hiking at a pace not seen since 1994.
As happened in the 1990s bond yields have risen sharply in response to the central bank action. At the same time, equity markets have also come under pressure. As one would expect, the increase in volatility has been most keenly felt in the government bond market. Long dated gilts, which have a higher sensitivity to inflation, have exhibited the same level of volatility as the UK equity market.
Investors who had thought that inflation linked bonds would provide a good hedge against rising prices have perhaps been in for an even greater shock. Many of these bonds, which are often used to hedge future liabilities, have low yields and often long periods to maturity. As a result, they have a high sensitivity to changing expectations about real interest rates. In recent months as real rates have increased, these bonds have seen significant movements in price. For example, the Treasury 0.125% 2046 inflation linked bond has more than halved in value from its level at the start of the year.
Around 18 months ago, it was increasingly clear to us at Treasury and Investment Office that the investment cycle was shifting. Although we clearly could not predict the level of monetary policy tightening we have seen, we started to do a lot of work around how the portfolio should be positioned for a period of rising interest rates.
At the time bond yields were very low, many developed market government bond yields were close to zero. In the corporate sector, US high yield was only yielding around 4% while BBB rated US corporate bonds (the lowest rated investment grade) was yielding little more than 2%. These historically low level of bond yields meant that there was very little income cushion within the asset class to absorb the impact of rising interest rates.
Given this backdrop we started to move some of the fund’s fixed income exposure into real assets. This included real estate, infrastructure and alternatives. Within the existing fixed income allocation, our strategy was to shift exposure away from western developed markets, which offered the least compensation for interest rate risk, and build exposure to emerging and Asian markets. These markets offer higher initial yields and diversification in terms of monetary policy.
We also added private credit, which typically has floating interest rates. This means that rising rates do not have a direct impact on their price. Within our remaining developed market exposure we moved down the credit spectrum holding more BBB and B rated bonds.
These changes meant that we began 2022 holding significantly less fixed income exposure across the funds that many of our peers, as well as a higher income cushion to offset losses from rising rates. As inflation has soared and central banks have tightened policy, we believe this approach could benefit the performance of both PruFund Growth and PruFund Cautious.
The question facing investors is whether the volatility we have seen in bond markets over the past 12 months is going to continue, or more succinctly does cautious remain cautious?
It is our view that there has been a paradigm shift in recent months. For much of the past 30 years inflation has been relatively benign. During this period there have been inflation scares, but whenever they have happened, for example during 2008, 2011 and 2017, price rises have not been sustained and inflation has quickly been brought back under control. This has enabled central banks to maintain their asymmetric approach to policy.
The policy response of central banks this year has shown that this era is over. The impact of Russia’s invasion of Ukraine has provided a supply-side shock that has led to an acceleration in prices. As inflation has risen, and its outlook become more uncertain, so too has the level of volatility within bond markets. This point was perhaps driven home to UK investors by the market’s reaction to Kwasi Kwarteng’s mini budget. Concerns about the inflationary impact of the new governments’ spending plans saw long dated gilt yields soar. It was only after the BoE’s intervention that yields came back under control.
As we look ahead, there is still considerable uncertainty. Inflation remains very high by recent standards and significantly above central bank targets. At the same time the global economy is clearly slowing and the prospect of economies entering recession is increasing. As a result the ultimate level that policy rates will need to reach in this cycle is still being widely debated. However, with inflation having regained its bite, one can expect central banks to err on the side of caution as they seek to bring it back under control.
In this environment diversification will be key to successfully managing risk. To achieve this we believe that investors need to broaden their investment universe both by geography and asset class looking beyond just bonds and equities. By doing so we believe that they should be better able to ensure that cautious does indeed remain cautious.
This content has been prepared by M&G Treasury and Investment Office (T&IO) and is prepared for information purposes only and does not contain or constitute investment advice. Information provided herein has been obtained from sources that T&IO believes to be reliable and accurate at the time of issue but no representation or warranty is made as to its fairness, accuracy, or completeness. The views expressed herein are subject to change without notice. Neither T&IO, nor any of its associates, nor any director, or employee accepts any liability for any loss arising directly or indirectly from any use of this document. The value of investments and any income from them may go down as well as up and are not guaranteed. Investors may get back less than the original amount invested and past performance information is not a guide to future performance.
‘M&G Treasury & Investment Office (T&IO)’ includes the team formerly known as Prudential Portfolio Management Group (PPMG). Prudential Portfolio Management Group Limited, is registered in England and Wales, registered number 2448335.