Why we’re no longer underweight government bonds

The year 2022 was one to forget for the global bond market as the world’s major central banks raised interest rates in a bid to control inflation. Rising interest rates mean the value of fixed income, or bond, securities fall, which can inflict losses for those that invest in them. 

Those new to the workings of fixed income, may want to read our recent blog ‘Everything you wanted to know about bonds…’ which explains, among other things, how interest rates impact the market, and the link between changing bond yields and bond prices. 

Historically, Nutmeg has held an underweight position in bond risk across our portfolios, reflecting the several spill-over effects of a decade of extreme policy actions; most recently support leant by governments during the Covid pandemic.  

A consequence of extreme monetary policy – most notably more than a decade of quantitative easing – was exceptionally low interest rates. During this time, the team has been wary about the need for rate normalisation and its adverse impact on the bond market.  

A further consequence of this is that western central banks have become major owners of their own government’s debt. As such, central banks have indicated the need to become net-sellers of bonds as part of their own policy ‘normalisation’ process.  

Nutmeg’s underweight bond position was rewarded last year, when bond prices fell sharply as interest rates rose – leaving investors nursing losses on investment assets that are typically seen as among the safest in financial markets. However, our lower-risk portfolios still experienced losses some investors may not have expected during the period given their high structural weighing to fixed income. 

We have been cautious about ‘neutralising’ our exposure to bond markets (versus our benchmarks) in recent months due to a range of factors, including the continued inflation pressures, the ongoing need for central banks to wind-down (sell) their holdings of government debt, and the potential for interest rates to reach higher levels than market expectations.  

Finally, rising interest rates were always likely to cause stresses in the financial system and this warranted additional caution. 

Why we are now neutralising our bond positioning 

However, we now believe it is the right time to neutralise our bond position and so have made changes where appropriate in our fully managed and socially responsible portfolios.  

Here are some of the considerations behind our thinking:  

• Although inflation data is now trending in the right direction, recent data releases are a reminder than central banks still have much work to do despite peak inflation rates being behind us.  
• Importantly, we are not seeing fresh inflationary pressures related to China’s economy reopening. Large upside surprises in inflation data appear less likely going forward, particularly as many labour market strength indicators appear to have passed their peak (but are by no means weak). Policy makers at the Federal Reserve still expect core inflation to fall to 3.6% by December 2023 and then to reach 2.1% by 2025, consistent with inflation trending lower in coming the months. 
• The US economy is now in the later stage of its monetary policy cycle, with the bulk of the heavy lifting interest rate rises behind us. And while we don’t expect an immediate respite to higher interest rates (market expectations of a cut to US interest rates later this year seem far too optimistic to us), the risk of interest rates moving materially higher from here appears lower than at the start of the year.  
• The failure of several retail banks over recent months has provided an additional reason for central banks to tread cautiously in hiking rates further. While there is no doubt the US financial sector remains in broadly robust health, the nature of some banks’ investments in bond securities means they too are exposed to rising interest rates, and the stresses inflicted on the banking sector through this period of rate rises is clearly visible. 
• The term ‘credit crunch’ is often used to describe a decline in lending or tightening of lending standards, where loans become harder or more costly to access as banks become more conservative in their practices. All this means mainstream banks may be doing some of the ‘tightening’ that central banks once may have had in mind to do. 
• Policymakers are acutely aware of the lagged effect of monetary policy (raising or cutting interest rates) and having witnessed the recent financial sector turmoil will potentially be inclined to take a more patient approach as the economic and inflation data evolves. 

Why invest in bonds? 

Along with a steady yield-based income, government bond assets typically offer investors a source of diversification given they tend to be negatively correlated with global stock markets.  

That wasn’t the case in 2022, as central banks were forced to play catch up with inflation data, hiking interest rates materially and inflicting losses on both bond and equity investors.  

However, with interest rates back to attractive levels, investors are being better compensated for the risk while correlations have partially normalised, and the diversification factor of government bonds is once again effective.  

The normalisation process is more advanced in the US than the UK. And it is the former where the Nutmeg team has increased our allocation.  The news on inflation outlook seems clearer in the US, and the communications spilling out from the US Federal Reserve seem more coherent and strategic. For the time being, we prefer US bond exposure to UK exposure, while all portfolios continue to have large holdings in UK bonds. 

The road ahead  

As global economies have entered the later stages of monetary policy tightening, the scene is being set for a stronger cyclical story for the bond market.  

Ordinarily that’s not a very positive equity market story and Nutmeg retains a modest under-exposure to equity risk, though little has been ‘ordinary’ about the last few years in policy, markets and economics.  

We continue to monitor the forces for positive growth as well as the cyclical sources of economic moderation and stand ready to adjust the portfolios as necessary. 

Risk warning 

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance.