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"Any investors attempting to tilt their bond portfolios towards shorter-duration bonds are potentially limiting their long-term return prospects."
While policymakers worldwide have continued to hike rates in the battle against persistent inflation, investors shouldn’t allow the sell-off in 2022 to cloud important long-term asset allocation decisions: in our view, hedged global bonds remain one of the most reliable long-term diversifiers to equity market risk.
What’s more, higher interest rates mean the return outlook over the long run has improved for investors in bonds, which in turn is good news for long-term investors in diversified multi-asset portfolios.
The challenge facing advisers and investors is the tendency for losses (negativity bias1) and recent experiences (recency bias2) to have an outsized impact on their decision-making – including investment portfolio decisions.
The question investors should ask is: will the next five or 10 years in bond markets be like the past 18 months? Our analysis suggests this is unlikely.
That’s because the catalyst for last year’s annus horribilis in global bond markets was a sharp upswing in interest rate expectations, with duration risk exacerbating the problem.
Duration risk refers to a bond or bond portfolio’s sensitivity to interest rate changes, accounting for characteristics such as yield, coupon rate and maturity. Bond prices move inversely to changes in interest rates, so that if interest rates rise (or fall), bond prices fall (or rise). The longer a bond’s duration, measured in years, the more sensitive its price to interest rate changes. As the chart below illustrates, duration (the shaded area) had been rising steadily since the mid-1990s before accelerating in the aftermath of the global financial crisis (GFC).
The explanation for this trend is two-fold. First, the exceptional monetary stimulus instigated by central banks after the GFC drove yields on short- and long-dated bonds down to historic lows. Second, bond issuers at the time saw an opportunity to refinance old debt by locking in the lower borrowing costs for longer (100- and 50-year bonds were issued in Europe as recently as 2021), effectively extending maturities and the repayment of principle.
Ultimately, amid the ultra-low interest rate environment, supply was met with demand as investors were willing to take on increased duration risk in the hunt for yield.
Duration risk steadily built up - then rapidly unravelled
Source: Bloomberg, Vanguard. Broad EUR bond market represented by the Bloomberg Euro Aggregate Index. Data from 31 December 1996 to 28 February 2023. Modified duration to worst refers to the duration of a bond calculated using the nearest call date or maturity, whichever comes first. Yield to worst refers to the lowest possible yield that can be received on a bond (accounting for callable bonds). Coupon rate (par-weighted, %) reflects average coupon for new bond issuances. Maturity refers to the time left before the bond issuer repays the principal investment.
As central banks raised rates faster than expected in 2022 to combat rising inflation and cut short their bond-buying programmes, bond yields soared and prices fell, with bonds with a longer duration the most impacted.
The important point for multi-asset investors to bear in mind here is that duration risk is now significantly lower relative to pre-Covid-19 levels and the likelihood of drawdowns in global bonds akin to those seen in 2022 has reduced as a result3.
Broadening our focus to global bond markets, volatility may continue in 2023 while the macroeconomic environment remains uncertain. Some investors might be tempted to deliberately tilt their bond exposures towards short-term bond funds or cash, given the yields available on short-dated debt and reduced sensitivity to interest rate changes.
The problem with this approach is that investors will at some point want to switch back to longer-duration bond funds before markets price in rate cuts. That’s because, as we explore above, long-duration bonds tend to benefit when interest rates fall, while short-duration bonds don’t. However, it can be very difficult for investors – even professional investors – to time the market in this way.
The next two charts break down the total return of long- and short-duration euro area aggregate bonds over nearly a quarter of a century and highlight how bearing some duration risk can pay off for investors over the long term. The data show that income return (green), when reinvested, compounds over time and drives the majority of total bond market returns – and also that the higher coupons offered by higher-duration bonds have powered outperformance versus short-duration bonds, which pay lower coupons.
The red-shaded areas illustrate the contribution of price return to total bond market returns. This shows how any investors attempting to tilt their bond portfolios towards shorter-duration bonds are potentially limiting their long-term return prospects, especially in environments of declining interest rates.
Total return analysis of long- and short-duration UK government bonds
Past performance is not a reliable indicator of future results.
Source: Vanguard calculations, based on data from Bloomberg. Data between 31 December 1999 and 30 June 2023. Notes: Pan-euro 7-10Y returns based on the Bloomberg Pan-European Aggregate: 7-10 Years Total Return Unhedged EUR. Pan-euro aggregate 1-3Y returns based on the Bloomberg Pan-European Aggregate: 1-3 Years Total Return Unhedged EUR. Returns calculated in EUR with income reinvested.
Ultimately, the main role of bonds in a long-term multi-asset strategy is to provide diversification against equity market risk. In our view, investors are unlikely to experience another drawdown in global bond markets of last year’s magnitude and further volatility should not detract from the long-term investment case on holding euro area bonds as part of a diversified multi-asset portfolio.
For more information on the dynamics of stock/bond return correlations, including in a scenario whereby stocks and bonds are positively correlated over longer time frames, click here.
1 See Kahneman and Tversky, 1979.
2 See Barberis et al., 2001.
3 Source: Vanguard, 2023.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Past performance is not a reliable indicator of future results.
Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.
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