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Is 2023 a good time to get back into bonds?

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Investors may be focusing on near-term headwinds, but longer-term returns are on the up, helped by rising bond prices.

Financial markets have witnessed heightened volatility over the past year as the world deals with a number of major issues including the disruption in global supply chains by the pandemic, growing natural disasters due to climate change and geopolitical conflict such as the Russia-Ukraine war.

The resulting surge in inflation has created immense uncertainty for investors around the world and pushed all major central banks to wage a war on rising prices by jacking up interest rates, even at the risk of slowing down economic growth.

The current set of circumstances has also created divergent paths for stock and bond markets.

Investors, particularly those who have previously focused only on stocks, need to pay attention to the increasing attractiveness of bonds.

Why are bonds more attractive now?

Bonds are basically an instrument to raise debt by any organisation, in return for paying interest at regular intervals.

Typically, when interest rates rise, bond prices fall and consequently their yield or return goes up.

As major central banks have started lifting interest rates from rock-bottom levels, bond yields have started to rise around the world.

For example, Australian fixed income securities currently have the highest yields seen for many years, making them attractive relative to other asset classes.

Bonds as a general asset class also have a lower risk than stocks and pay a regular return, factors that become more important during uncertainty.

This is particularly relevant for investors wanting to guard against the risk that central banks will overplay their hands to tame inflation and tip economies into a recession.

Anthony Kirkham, portfolio manager for the $1.4 billion Western Asset Australian Bond Fund, says his fund's cash flow yield is currently around 4.7% – a far cry from the yield of 1.1% in August last year.

"It has been painful to get to this point, but we now have confidence that given the outright level of yields available in the market, fixed income's ability to provide defensive attributes to a broad range of risks is fundamentally re-established."

Time to get back to a 60/40 portfolio?

As mentioned earlier, periods of slowing economic growth typically create divergent paths for stocks and bond markets.

Uncertainty in earnings leads to lower valuations and returns for company shares. By contrast, bonds offer better yields by virtue of rising interest rates.

The optimum balance is a combination of portfolio holdings in both markets – what analysts at JP Morgan call the 60/40 stock-bond portfolio.

In its latest Long-Term Capital Market Assumptions (LTCMAs) for 2023 JP Morgan Asset Management says forecast annual return for a USD 60/40 stock-bond portfolio over the next 10–15 years leaps from 4.30% last year to 7.20%, given the changing macro environment.

"The latest LTCMAs forecast shows that the core principles of investing still hold firm after a year of turmoil – 60/40 can form the bedrock of portfolios," said Leon Goldfeld, Asia Pacific head of multi-asset solutions at JP Morgan Asset Management.

"The painful slump in stock and bond markets in 2022 may not yet be over, but over the longer term we see this year's turmoil creating the most attractive investment opportunities we've seen in a decade."

The investment bank says while many investors are rightly focused on elevated inflation and other near-term headwinds, inflation is expected to cool over the next couple of years and long-term return projections have shifted meaningfully higher.

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