The problem with ‘global bonds’ and M&G Wealth’s approach to fixed income

Bonds are an important part of a multi-asset portfolio. They help to reduce the portfolio risk, which is particularly important for customers that are drawing income from their investments. They are inherently safer than stocks because they have a higher status among creditors. In this article we look at the problems with a simple allocation to ‘global bonds’ and how we think bonds should be used to get the best results for customers.

The problem with ‘global bonds’

A bond faces two main risks: interest rate risk (the sensitivity of a bond’s price to interest rates) and credit risk (the risk the bond issuer won’t be able to make the required debt payments to the bond holder).

Looking at Investment Association data, a typical multi-asset portfolio’s allocation to bonds is a mix of ‘global bonds’, UK gilts and UK corporate bonds. Global bonds are mostly US sovereign bonds (treasuries) and sovereign bonds from other developed economies such as the UK, Europe and Japan. UK corporate bonds are sterling denominated bonds issued by high quality companies. The main risk for these types of bonds is interest rate risk. There isn’t a large risk of the bonds not being repaid.

Bond prices and interest rates move in opposite directions; when interest rates rise bond prices fall and visa-versa. In 2022, interest rates rose sharply and prices fell sharply. A portfolio of gilts and global bonds didn’t face credit risk; there was never a reasonable doubt that the UK, US, Europe or Japan governments would fail to repay the debt they owed to bond holders. Instead, the value of this mix of bonds was eroded by the rise in interest rates. The key here is that both the global bonds and the gilts were exposed to the same type of risk.

Our approach to fixed income

Our asset allocation is about identifying risks and opportunities based on what could happen in the future. We look at where we think returns will come from looking out over the next 10 years and how to avoid the potential risks. This leads us to holding a broad range of fixed income investments.

Our view is that ‘global bonds,’ like UK Gilts and US Treasuries, still face risks. We don’t think inflation will fall back to the target 2% pa level. In the future, we think holders of government debt will require an additional yield, or ‘premium’, for higher inflation eroding more of the value of a bond. A lot of the debt created during the pandemic and the subsequent recovery was taken on by governments rather than households or companies. This means holders of government debt will require more yield to compensate for this risk, as well as the need to issue future debt to pay for things like the energy transition and an aging population.

We have a small allocation to developed market government bonds. The majority of our fixed income exposure is in investment grade bonds across the UK, Europe and the US. Investing in high quality corporate bonds offers a higher interest rate via the credit premium and has less interest rate risk than holding global bonds.

Our fixed income exposure also has geographic diversity through areas such as:

• High yield bonds – these bonds have higher levels of credit risk and a small amount of interest rate risk
• Emerging market debt – these bonds are issued by emerging market countries, and have exposure to a diversified set of economies
• Asia bonds – these are bonds issued by governments or companies in Asia, with some credit risk

How this approach helps customers

Better future returns: Looking forward we think corporate bonds and emerging market bonds will deliver better returns than government bonds. We estimated the difference is 1 – 3% additional return per year over ‘global bonds’ for the next 10 years. But we also think incorporating corporate bonds and emerging market bonds is essential for managing risk within portfolios.

Better fund performance: When implementing our allocation to bonds we allocate to managers who have specific expertise in picking the best UK corporate bonds or high yield bonds. For a global bond manager there are a lot more variables, such as which regions to consider, what type of bonds, and which individual bonds. We think more outperformance can be generated by managers who are experts in their specific area of fixed income. 

Better portfolio diversification: The table below shows the correlation between different fixed income asset-classes. UK gilts and global bonds face the same risk – the risk that interest rates change. Thus they move up and down together with a high level of correlation and offer very little diversification within the portfolio. Emerging market bonds and high yield bonds face different risks and are aligned with different economic cycles, making the correlation to global bonds much lower. This played out in 2022. A portfolio of global bonds and gilts fell roughly 20% in 2022 compared to -10% for a diversified mix of sovereign bonds, investment grade bonds, high yield and emerging market debt.

The table below shows the correlation of returns between fixed income asset-classes. The data is based on monthly returns over the last three years. The correlations highlighted in red indicate a high positive correlation. Green shows lower correlation of returns.

Why do many multi-asset strategies use global bonds and gilts?

We can’t know for sure, but this is our take. Some managers use past performance, such as the historical risk and returns of different asset-classes, to set their asset allocation.  Prior to 2022, Gilts and other developed market sovereign bonds had a fantastic risk-adjusted return; UK gilt yields went from 7% pa to 0% pa from the mid 1990’s to the beginning of 2022. In contrast, the historical return from emerging market debt was poor over the same period. The number of emerging market countries that issue debt has increased from 4 in 1991 to 80 today, meaning that going forward if one country defaults the impact on returns will be much lower. Looking at historical emerging market bond performance of four countries bears little resemblance to looking at what could happen over the next 10 years.

Our approach is about identifying the long-term growth opportunities of different markets, looking at possible scenarios for inflation and monetary policy. We consider how this might impact correlations between asset-classes and how volatility and the importance of interest rate risk is changing. This enables us to build portfolios for customers where bonds are able to deliver good returns and provide diversification when needed.

Past performance is not a reliable indicator of future performance. The value of an investment can go down as well as up and your client may get back less than they’ve paid in.