Why bonds are back in vogue with investors

It's fair to say that 2022 was not the greatest year for many investors. Equity markets lurched up and down like a ship on a stormy sea, and fixed income had an even less stellar time of it.

"2022 was a tumultuous year for pretty much every asset class other than cash and commodities, and fixed income wasn't spared from that very large drawdown as we saw asset prices readjust to what was effectively a new regime around monetary policy settings," explains Mihkel Kase, portfolio manager for fixed income and multi-asset at Schroders Australia.

The reason? Like many parts of life last year, Kase says that bond values were impacted by the rise in inflation and subsequent monetary policy action taken by the central banks to address it.

2023 appears to be shaping up in a different way altogether for fixed income though - at least, if investor interest in bonds is anything to go by.

According to online investment platform Stockspot's 2023 ETF Report, bond exchange traded funds actually edged out other ETF categories like global and Australian shares in attracting the largest net inflow of money from Australian investors in the 12 months to June 30.

"We've found that while bonds and the broader fixed-income asset class had experienced some of their worst performance in decades during 2022, bonds are attracting significant inflows in 2023," says Stockspot founder and chief executive, Chris Brycki.

"We've been researching the more than 250 ETFs on the ASX and Cboe Australia for ten years now and this is the first time we've seen bond ETFs getting so much interest."

A more attractive outlook for bonds

So what are some of the causes behind this recent lift in investor interest? For Kase, there have been a couple of recent positive changes from a bond market perspective.

"First of all, we've had some improvement in valuations. Yields have increased significantly and, as a result, they're giving income where they hadn't been giving income for a period of time, and improved valuations can then provide improved diversification to the other parts of a portfolio."

As an asset class, the outlook for the rest of the year is also looking positive, though Kase cautions that uncertainty around the inflation situation may dictate how investors want to manage their holdings.

"From a cyclical perspective, the outlook for bonds has also improved. Our view is that we're likely to have a recession especially given the significant monetary policy tightening we have seen. Hence, from a cyclical perspective, bonds look attractive."

"We expect inflation and rates to be higher for longer and, as a result, people will need to actively manage their exposures. But it has definitely improved from levels where yields were very, very low and effectively they had an inability to provide diversification to risk assets."

What place do bonds have in a portfolio?

While there appears to be plenty of enthusiasm for bonds at present, those without any existing exposure may be curious as to the role they can play. For Brycki, the ability for bonds to perform well when other assets are doing the opposite can be crucial in a well-rounded investment portfolio.

"During economic downturns when interest rates are falling, bond prices tend to rise, making them an attractive option. Conversely, in times of economic expansion, bonds become less appealing.

"This inverse relationship with shares makes bonds a defensive asset. As a result, the combination of bonds and shares can act as a stabilising force, smoothing the ups and downs of your overall portfolio.

"The other significant advantages of holding bonds is the reliable income they provide through interest distribution payments. As most of the investment return from bonds comes in the form of interest distribution income, including bond ETFs, which contain a diversified portfolio of bonds."

While Brycki is a fan of bond ETFs and the relatively low costs associated with them, Kase believes a strategy of active management is important - especially at the moment.

"I think, typically, a lot of investors' portfolios are underweight in fixed income - it's one of those asset classes that they're not as familiar with in terms of concept and duration. And I think 2022 probably turned investors off given that it's supposed to be defensive, but gave them large drawdown.

"So we still think it plays an important role in portfolios in that it can provide yield and diversification, but we think it needs to be actively managed."

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