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Bonds are back - Here's why

It has been an extraordinary time for bond markets.

As an asset class, fixed income is often seen as equities’ boring cousin, particularly over the past decade of low yields. Recent months, however, have been anything but boring, albeit for the wrong reasons.

Bonds have seen a record decline, but may now be presenting some of the best value in many years. This coincides with the economic environment becoming more supportive of the asset class.

There are three main reasons why bonds are particularly attractive at the moment:

  1. Valuations: yield levels are appealing again and there is good return potential here.

  2. Bonds are a good diversifier, particular in periods of economic uncertainty.

  3. We believe that the number of rate hikes currently priced into bond markets won’t be delivered as inflation peaks and growth slows.

What has driven the drawdown in bonds?

Between January 2021 and mid-May 2022, global fixed income declined -17.6% (Bloomberg Global Aggregate Bond Index), the biggest drop since data began in 1990. In comparison, the peak to trough decline during the 2008 Global Financial Crisis was -10.8% (see chart).

Record decline creating value in bonds

Since the start of 2022, bonds have found themselves facing a combination of multi-decade high inflation and a hawkish shift from the major central banks. A change in rhetoric and messaging from policymakers has translated into realised rate hikes.

The narrative on inflation has shifted decisively. Prior to mid-2021, central banks were convinced high inflation would prove transitory, as a by-product of Covid-related pent up demand and supply chain disruption.

However, policy makers have become increasingly uncomfortable with the prolonged nature of inflation, particularly given signs of second-round effects feeding through into wage growth.

Added to this is the uncertainty surrounding the war in Ukraine, and the ongoing Covid pandemic, with parts of China currently under stringent lockdowns.

From a purely economic or investment perspective, these factors are fuelling already potent inflationary forces as additional supply side constraints and disruption drive commodity prices higher.

Stunning market move

It is not surprising bonds have suffered given these circumstances, but the velocity of the move has been staggering. In some instances, entire economic cycles have been fully priced into valuations in a matt