Bonds: not the multi-asset building blocks they used to be

19^th April 2021 | Keith Balmer, Director, Product Specialist, Multi Asset Solutions

The first quarter of this year has seen a steady increase in inflation expectations – reflecting investors’ fears that inflation will continue to tick upwards. Are these fears justified, and what does this mean for the return potential of bonds?

Inflation – what’s your measure?

There are many types of inflation measures, from RPI to CPI, month-on-month measures to estimates of inflation in five or ten years’ time. Recently, there have been increasing worries about rising inflation, but are these fears justified? On face value, the fears do appear to be justified; goods prices, such as food, metals, oil and house prices, have been rising, and this is to be expected as the global economy in varying degrees starts to move out of the virus-induced lockdowns. Added to this, there are some technical effects that will cause higher inflation in the short term. Year-on-year inflation will soon start to compare the sharp declines in prices seen at the start of the pandemic lockdowns in April to June of 2020, with current prices. This will feed through to higher levels of inflation, but these will only be temporary.

We think it is more helpful to look at inflation expectations further ahead, i.e. what investors think the path of inflation will be in the medium term. These measures have started to decline, having risen consistently since the pandemic hit in early 2020, which suggests that there will not be a sustained rise in inflation.

Reflation – starting from a low base

So, whilst there are some technical reasons that inflation may rise in the short term, we do not think there will be a sustained rise in inflation in the near term. There are fundamental reasons that allay our fears of rising inflation, such as the excess slack in the labour market and longer-term structural dynamics.

So how does this all affect bond yields? Well, if the market was technically driven, then the longer-term fundamental factors that are in place to keep inflation low should mean that there is no call for central banks to change policy to control inflation. The massive amount of stimulus that has been put in place by many countries also means that governments will want to keep bond yields low in order to keep the cost of repaying this huge debt burden manageable. However, markets are not rational, and these two factors for bond yields staying low can easily be dismissed by markets driven by news flow of economies opening up and headline inflation numbers. Even rhetoric from central bank policy-makers could drive investor fears of runaway inflation:

Although we have seen a rise in bond yields in recent months, this has mainly reflected increases in inflation expectations, and we need to remember that the yield rises are from a very low level.

What does this all mean for multi-asset portfolios?

Despite some potential small rises in bond yields, we expect yields to stay way below their longer-term historical average; and although we anticipate that yields will grind slowly higher into next year, we believe that fears of runaway inflation are overdone. For some investors who invest in balanced portfolios with limits on asset allocations, or that are tied to certain indices, they may be forced to hold certain types of bonds where there is limited return potential, and arguably increased risk.

For active multi-asset portfolios, where the target weights are not constrained by fixed government or geographical bond limits, portfolio managers can allocate their fixed income portion to global corporate bonds where the return potential is more attractive, and the sensitivity of the bond to movements in interest rates is much lower than government bonds or index-linked bonds. Specifically for our range of multi-asset funds, we have been moving lower in our weighting to government bonds since the latter months of last year, and in some higher risk-rated funds we hold no government bonds at all. In the lower risk-risk rated funds where it is not appropriate to hold a high proportion of equities, we have lowered our government bond allocations in favour of cash, as we see this as a better way to preserve capital in the current climate.

For more information on the asset allocations and risk profiles of the Universal MAP ranges, please contact the BMO sales support team.

Risk Disclaimer 

Views and opinions expressed by individual authors do not necessarily represent those of BMO Global Asset Management.

The value of investments and any income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested.