It’s time to tilt portfolios extra into bonds | USAEMALL.com

Unlock the Editor’s Digest for free

Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

The writer is chief economist and head of investment strategy group at Vanguard Europe

Almost everyone in markets appears to believe that interest rates are close to moving off recent peaks. Central banks are expected to lower rates as they gain confidence that inflation is on track back to target. Some, like the European Central Bank and the Bank of England, have already started. The most important central bank, the US Federal Reserve, is likely to start cutting its benchmark rate next month from the current range of 5.25 to 5.5 per cent.

Rates are likely to settle at or closer to what is known as the neutral rate, or r-star, the level that neither stimulates nor restricts the economy. Importantly, although rates will fall, they will not end up as low as they were prior to the Covid pandemic. We are entering a new regime where bonds offer greater value in a portfolio.

How does a high-rate regime affect portfolio choice? History is a good place to start.

My colleague Dimitris Korovilas and I look back nearly a century and consider the interest rate regimes the US has experienced. By comparing actual interest rates and our own estimate of the neutral rate to their median values over the past 90 years, we classify these regimes into high- and low-rate periods. When the interest rate is below the median, we classify the period as low rate, and vice versa. The different interest rate regimes are the result of the type of economic shocks hitting the economy as well as the policy framework and stance.

Between 1934 and 1951 interest rates were low. The US 3-month Treasury bill rate, which tracks the US benchmark federal funds rate, averaged 0.5 per cent. Thereafter, interest rates rose, peaking in the mid-1980s. Between the late 1950s and 2007, the average interest rate was high, at 5 per cent. After the financial crisis, the US entered a low-rate era with rates around 1 per cent. More recently, interest rates have risen, and we estimate that they will settle around a neutral rate of 3-3.5 per cent.

To understand what these regimes have meant for investors historically, we look at 10-year-ahead returns, using data back to 1984, and split periods into high- or low-rate regimes.

In high-rate regimes, 10-year-ahead actual returns for global stocks and bonds were similar at just over 7 per cent annualised. But stock returns were four times more volatile than those of bonds. Because bonds offered the same returns for lower risk (volatility), their performance relative to equities was particularly attractive on a risk-adjusted basis.

In contrast, in low-rate regimes, 10-year-ahead actual returns from bonds were approximately 4.5 per cent, with global stocks returning 8 per cent. Stocks offered a hefty premium over bonds. Volatility of stocks and bonds is similar across regimes, making bonds relatively less attractive on a risk-adjusted basis.

Given we are in a high-rate regime currently, what does this mean for investors today? Past is not prologue. Assuming no new significant economic or political shocks, Vanguard projects 10-year-ahead returns for global stocks at just above 5 per cent and returns for global bonds at just below 5 per cent. This forward-looking assessment rhymes with history: in a high-rate regime, bonds offer greater value in a portfolio.

Our projections embody the view that US equity valuations are stretched relative to fundamentals. The pain of higher interest rates is yet to be fully felt in global stock markets.

For a balanced investor, who holds stocks and bonds in roughly equal parts, the higher interest rate environment and associated better bond outlook is good news. It means that bonds offer greater value to the portfolio than before, not only in their typical role as a diversifier but also as a source of returns.

There is merit to holding some bonds in any environment, particularly in today’s higher-rate regime. Some investors may go further and tilt their portfolios towards bonds. This might better balance the higher certainty of better bond returns with the less certain similar returns from equities.

Everyone needs to be wary of the risks of investing and how much of that is built into model projections. Our view is that interest rates are going to settle at a higher level than pre-Covid, and that US equity valuations are stretched. History and our model projections suggest that in a high-rate regime, bonds offer greater value in a portfolio from both a return and a diversification perspective. When regimes change, investors should at least reassess their portfolios.