Deep Dive: Government bonds ‘at least investable again’ after fixed income ‘horror show’ in 2022

The senior investment consultant recalled how the asset class underwent negative capital returns and a higher correlation to the equity markets than investors expected.

Debate around the appropriateness of the 60/40 portfolio was spurred by these lacklustre opportunities and returns in the traditional ‘safe haven’ asset class, with some experts calling the death of the classic diversification split.

Alternatives such as infrastructure were pitched as the fixed income alternative by fund pickers, as they seemed to provide some counterbalance to the equity market downturn last year.

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Stuart Edwards, a fixed income fund manager at Invesco, echoed Angell’s initial comments, stating: “I have spent my career observing government bond markets and managing funds with big government bond exposures.

“If you had asked me a little more than a year ago to write a note on the asset class, I may have struggled to produce interesting prose.”

But he did not totally write-off the asset class, stating that now, after the all-time lows following the Covid crisis, he sees an asset class which is “at the very least investable again, if not quite a screaming ‘buy’ currently”, noting he was now happy to take duration risk again after years of abstaining. 

Angell echoed that “with every fall comes opportunity”.

Three drivers

Government bonds fit under the broad umbrella of fixed income, and the outlook for this asset is not equal to the whole sector.

Eric Lascelles, chief economist at RBC Global Asset Management, said the asset class had three main drivers: debt, inflation and growth.

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The former has been “incrementally deteriorating for decades”, while inflation had been dormant for years “until a recent cataclysmic outburst”. And the latter, growth, “could be on the cusp of swooning, albeit temporarily”.

“There is a lot happening” in this corner of the bond market, Lascelles added.

Inflation-linked bonds and government bonds

Several commentators flagged inflation as a key factor in deciding the role of government bonds this year.

Arguably, high inflation is the prime time for inflation-linked assets. However, Angell said that while inflation-linked bonds could provide some defence, they tend to be longer-dated and therefore carry additional risk – and opportunity – with respect to any movements in interest rates.

Last year, the 0.125% Index linked Treasury Gilt fell further than the Bloomberg Galaxy Bitcoin index, according to data from Bloomberg.

In an environment where inflation remains, he favoured shorter-dated, inflation-linked and government bond funds for the “most appealing risk/reward pay off in an environment where high inflation rates are likely to persist and interest rates could go either way”.

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But inflation has been tracking down in core markets after a year of generational highs, which could see central banks shift on its current “emergency” policies, Lascelles noted.

“We flag the potential for incrementally lower yields over the year ahead as inflation falls by more than the consensus currently expects, as the economy descends into a recession that is not yet fully priced, and as central banks are able to curtail their tightening slightly ahead of schedule in response to the first two developments,” he said.

“From a demand perspective, as the uncertainty around inflation and rate hikes begins to diminish, investors are flooding into some of their most attractive fixed income valuations in decades.”

While a recession may not be fully priced in, it has at least been signposted for some time, as well as the slowdown in global economic growth.

According to Angell: “Predicted economic recessions and slowdowns understandably leave some investors wanting fixed income exposure shielded from company credit risk.”

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Gary Kirk, a founding partner of Vontobel, petitioned the benefits of government bonds versus credit at this point in the market, since the latter “attracts greater volatility”.

Although credit offered income to investors, government bonds were typically seen as the go-to asset to make the ride smoother during periods when market volatility escalates, although 2022 challenged that trend, he said.

For him, government bonds remain a “key role” in fixed income portfolios.

“As a fixed income fund manager, with government bonds you are primarily looking to give balance to a portfolio,” Kirk added.