Bonds offer attractive combo of returns and diversification

Bonds — frequently used as a diversification tool — are also attractive for their return potential in the current economic climate, says Jack Delany, senior portfolio manager with the multi-asset team at Irish Life Investment Managers.

Delany said high-quality bonds offer positive outcomes for investors regardless of where yields go.

“It’s no longer necessary for yields to fall in order for government bonds to deliver a return,” he said. “When bond yields are low — and if we cast our minds back to just 2020, the 10-year Canadian government bond yield was at 0.5% — the way to generate return was for yields to move even lower. Now, with 10-year yield trading at close to 3.5%, even if yields don’t fall from here, you can still earn a return.”

Delany said the landscape has fundamentally changed.

“Less than five years ago, about 40% of the global stock of government debt was trading at negative yields,” he said. “We’re in a very different environment now, with yields having moved significantly higher.”

He said prevailing yields make for a good entry point for investors and are typically a good indicator of future returns over the medium to long term. The potential for lower yields in the future should benefit longer-duration positions, particularly relative to cash.

Falling interest rates should also provide a powerful tailwind, he added.

“Bonds are now offering a very attractive combination of both return opportunity and diversification potential. They look attractive on a standalone basis now,” he said. “Because yields are high, that can mean strong returns. We think yields will fall, and that should also mean strong returns.”

On top of all that, bonds maintain their traditional diversifying role against a portfolio’s riskier assets, like equities.

“When we take these pieces together, bonds can be a very powerful tool in investor portfolios,” he said. “If I were to try to encapsulate all of this into a snappy title I’d say, ‘bonds are back.’”

Delany said the timing of rate cuts has been clouded by stubborn inflation. He does not expect the first Fed cut until July at earliest. In Canada, a rate cut is still possible in June.

“The data has been a little bit softer here, and Bank of Canada governor Tiff Macklem suggested after the recent governing council meeting that they were already seeing the progress they needed in order to cut rates, albeit that they needed to see it for a little bit longer,” he said.

When rate cuts arrive, longer-dated bond yields are expected to move lower.

“This also translates into longer-dated fixed income assets outperforming cash after peaks in policy rates,” he said.

Wider opportunities

Delany said it is not just high-quality government bonds that look attractive.

“If we cast the net a little more broadly, we’re also seeing opportunities in the riskier higher-growth portions of the fixed-income market, particularly in areas like high-yield bonds and emerging market debt,” he said.

Within high yield, he said all-in yields are attractive at around 7%. And while spreads are “somewhat tight,” even if they widen on the back of growth concerns, he expects Treasury yields to fall, offsetting the effect.

Emerging market debt — denominated in either local or high-quality foreign currency — also offers attractive valuations, with yields ranging from 6.5% to 7.5%.

“That’s a level that’s historically been consistent with strong return generation,” he said. “So we would see these riskier segments as well placed to complement a core fixed income allocation to high-quality assets, or indeed within an overall multi-asset portfolio as a complement to other growth assets such as equities.”

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This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.