IN FOCUS6-8 min read

With recent market shifts indicating that rates are peaking, is now the time to revisit government bonds?

History suggests now could be an opportune time to start moving from cash into government bonds.

11/12/2023
Regime shift

Authors

Karen Wright
Associate Investment Director, Global Unconstrained Fixed Income
Michael Lake
Investment Director, Fixed Income
Jonathan Snow
Investment Director, Fixed Income

With cash deposits yielding higher interest rates and fixed income having experienced significant volatility, it is not surprising that investors are currently keen on parking their assets in cash. With one of the most aggressive rate hiking cycles in history having driven an unprecedented sell-off in government bonds, investors can be forgiven for wanting to keep their powder dry.

However, with recent market shifts indicating a potential change in rates, there are now several compelling reasons to reconsider investing in government bonds. Below we discuss the three most prominent ones.

1.Government bonds look cheap

After a challenging few years, government bonds are now looking cheap compared to their historical prices and relative to other asset classes, including equities. In fact, US Treasuries are now back to pre-global financial crisis levels.

Higher coupons also offer a genuine alternative to other income generating asset classes, including equities, for the first time in many years.

And it’s not just the level of yield that’s important, but the level of protection the higher coupon (or income) provide investors. A government bond return is made up of two components - price and income - so the higher level of consistent income means you can be exposed to greater price depreciation before experiencing total return losses.

CHART 1: Higher coupons provide a buffer from capital losses.

Higher coupons provide a buffer from capital losses

2. The macro outlook …. and what history tells us about bond performance when rates peak

At their current yields, government bonds are already serious competition for cash. But when you consider the additional kicker you get from yields potentially falling - in that it is possible for bonds to achieve higher returns than indicated by their current yield to maturity– it makes case for government bonds even more compelling.

The global macro picture is a big driver of directionality in government bond markets due to their sensitivity to inflation and interest rates. We’re getting more encouraging news on both of these fronts, effectively removing two of the main headwinds government bonds have faced in recent years.

Our base case is that the global economy is able to achieve a soft landing (a gradual economic contraction). However, we can’t ignore the increasing warning signs that the landing might be harder, prompting central banks to ease monetary policy conditions once more.

We’re not saying that the next rate cutting cycle is imminent, but we are aware that when the market starts pricing in such a scenario, it will provide additional support for government bond markets. It would also mean a fall in deposit rates making cash a distinctly less attractive option and a greater reinvestment risk for those in short-term fixed deposits.

Most importantly, investors don’t need to wait for an easing of monetary policy conditions for it to pay to invest in government bonds. With slowing growth and inflation, and most developed central banks nearing the end of their rate hiking cycles, history shows that this is often when bond investments yield the highest rewards.

In fact, evidence suggests that government bonds have consistently outperformed cash in the immediate period following the final rate hike of a cycle.

The chart below illustrates this trend, displaying the outperformance of US Treasuries over cash in the one- and three-year periods post the final Federal Reserve rate hike of a cycle. Recent signals from policymakers indicate that we are nearing the end of the rate hikes, making it a good time to reconsider government bonds.

CHART 2: Government bonds consistently outperform following the peak in interest rates

Government bonds consistently outperform following the peak in interest rates

3. What will happen to equity/bond correlation?

Market timing is notoriously difficult to predict. Historically, government bonds and equities have had a negative correlation, meaning that when equity returns are negative, government bond returns tend to be positive, and vice versa. However, during periods of rising interest rates, these correlations are more likely to be positive. Recently, an intense inflation-driven rate hiking cycle disrupted this normal relationship and caused a shift in correlations.

Nevertheless, there are indications that the traditional relationship between government bonds and equities are set to return. As you can see from the chart below, when unemployment starts to rise (as it is now) equity/bond correlations tend to turn negative. This is because central banks are likely to respond by cutting interest rates. If this trend continues, government bond markets are set to become a good diversification source once more.

CHART 3: US Treasuries / US equities rolling correlations versus unemployment

US Treasuries / US Equities rolling correlations versus unemployment

High debt levels are just one reason to take an agile approach with bonds

While government bond markets continue to face challenges, there are still opportunities to be found. The significant supply required to fund government expenditure, coupled with the enforcement of quantitative tightening (a monetary policy tool used by central banks to reduce liquidity or money supply in the economy), has generated headwinds in specific markets.

Yet these challenges can also unveil opportunities, particularly when adopting an active approach to government bond investing that employs various techniques to boost returns.

Such techniques include managing overall duration, capitalising on cross-market divergences, implementing yield curve strategies (investment strategies designed to take advantage of anticipated changes in the shape of government bond yield curves), and making strategic asset class allocations, such as investing in government-related securities that provide a premium over government bonds.

Finally, we think that the key to navigating market risks going forward is to take an agile approach.

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Authors

Karen Wright
Associate Investment Director, Global Unconstrained Fixed Income
Michael Lake
Investment Director, Fixed Income
Jonathan Snow
Investment Director, Fixed Income

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