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Despite the sell off, bonds still have a lot to commend them, says Quilter

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The recent rise in bond yields should not spook investors, with fears about their lack of diversification ‘overblown’, according to CJ Cowan, assistant portfolio manager at Quilter Investors.

Recent weeks have seen bond yields jump back up to levels not seen since prior to the Covid pandemic as investors begin to worry about the threat of inflation and the impact this will have on central bank policy.

This caused some turbulence in the equity market and a sell-off in shares of growth companies. Meanwhile many investors are questioning the role of fixed income in a portfolio in an environment where bonds and equities are falling at the same time.

However, Cowan believes people’s fears are misplaced and that bonds continue to play a crucial role within a portfolio.

“The theory that bonds no longer offer diversification to equities has likely been overblown,” Cowan says. “The yield move over the past six months is up there with some of the fastest moves in recent memory, yet global equities remain close to all-time highs. Government bond yields plummeted last March as the whole world shut down so a corresponding increase in interest rates as vaccines are rolled out and growth expectations improve is entirely justified.

“It’s been well publicised that inflation is set to temporarily increase, and as this happens it wouldn’t be surprising to see bond yields continue to move higher, but how high can they really go?”

Cowan says bonds are worth keeping in a portfolio due to the demographics at play. He points to Japan as an example where huge swathes of government debt do not necessarily equate to a material increase in yields.

“Ten years ago, Japan’s debt to GDP ratio exceeded 200 per cent and it has kept rising, yet its yields remain stubbornly low. Like Japan, much of the developed world has an ageing population and thus demand will remain strong for low-risk assets such as bonds. This should put a cap on yield rises.

“With a larger debt pile, every increase in yields has a more pronounced effect on debt servicing costs, which is a drag on growth. So if required I would expect action from central banks to prevent yields getting out of control.”

Indeed, Cowan believes the latest sell-off, if anything, has helped to restore diversification properties for investors.

“There is now more room for bonds to rally before yields hit zero should we experience another growth shock. The economic recovery is not certain given the presence of virus mutations and questions around the strength of the bounce back in consumer spending. This certainly isn’t our base case, but it remains a risk.

“Moreover, as bond yields rise it brings back a level of income that has been missing for many investors, and of course bonds don’t just end at sovereign debt. In particular our managers with more flexible mandates are seeing plenty of opportunities, so the wholesale worries surrounding fixed income appear a little extreme.

“Markets are clearly very on edge just now, so continuing to have a broad range of assets in a diversified portfolio will ultimately serve investors best in an uncertain recovery.”

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