Weekly Bond Bulletin

1 October 2020

Can bonds still act as a ballast?

One of the primary motives for investing in fixed income is the ballast it has historically provided to an overall investment portfolio. But as yields continue to march lower, do core bonds still offer this portfolio hedge?

Fundamentals

Although the future continues to be fraught with uncertainty, one thing is certain: central banks will remain accommodative for an extended period. In the US, the average inflation targeting approach outlined by the Federal Reserve (Fed) actually describes a very unusual environment, as there have only been 22 months in the past 50 years when the personal consumption expenditures price index actually met or exceeded the 2% level. Elsewhere, central banks such as the Reserve Bank of Australia have indicated that there may be further rate cuts to come, while the Bank of England continues to contemplate negative rates. Whatever the easing tool of choice, it’s clear that monetary policy will keep a cap on yields. More recent virus developments also suggest that government bond yields are unlikely to move sharply higher in the near term. With the pick-up in cases, high frequency indicators have shown a slowing in activity. This dynamic is starting to feed through to economic data, with services purchasing managers’ indices falling across the US and Europe.

Quantitative valuations

Although developed market government bonds may not offer the hedge they used to, they still managed to generate positive returns in a month when equity markets sold off. As the positive momentum in equities reversed in September, resulting in a -3.8% return over the month for the S&P 500, developed market government bonds posted a total return of 0.7% over the same period. Notably, German Bunds—which started the month yielding -0.4% in the 10-year part of the curve—generated a 1.0% return, proving that even negative yielding bonds can offer an element of ballast to a portfolio. 10-year US Treasury yields may be towards the low end of our expected 0.5%-1.0% range (at 0.68%), but the catalysts that would push them meaningfully higher—namely, further fiscal stimulus, a vaccine or the removal of US election uncertainty—are unlikely to materialise until later in the quarter. (All data to 30 September).

Government bonds generated positive returns amid the risk sell-off in September

Source: Bloomberg, Barclays, Bank of America Merrill Lynch, J.P. Morgan. EM: Emerging markets, IG: Investment grade. As of 30 September 2020.

Technicals

Technical factors are also contributing to the supportive environment for government bonds. Powerful bond buying programmes from central banks have proven more than capable of soaking up the increased government bond issuance that we are seeing as a means of funding fiscal spending measures. In the US, the Fed is also committed to maintaining a functioning market. Any sign that US Treasuries are not acting as a hedge—such as earlier in the year, when 10-year Treasury yields rose 65 basis points between 9-18 March at the same time as stocks fell almost 20%—will likely spur the Fed to take further action.

What does this mean for fixed income investors?

The risk-off market environment in September has reinforced the importance of a balanced portfolio. As investors have sought to build ballast into their asset allocation, it has raised the question as to whether core government bonds still offer this attribute—or whether alternative sources of portfolio ballast, such as short positioning in emerging market currencies, should be considered instead. While the most effective risk hedge remains unclear, we believe that core government bonds, particularly relatively higher yielding markets such as the US and Australia, are an attractive portfolio diversifier.

About the Bond Bulletin

Each week J.P. Morgan Asset Management’s Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.

Click here to read more about our FQT capabilities


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1 October 2020
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