2022 was a shock, even if the problem had been widely foreseen. As inflation ran higher in the aftermath of the Covid pandemic, policymakers were forced into a swift and brutal rise in interest rates. Equity and bond markets sold off in parallel, leaving many advisers to have uncomfortable conversations with their clients.

The recent US market sell-off was eerily reminiscent of this uncomfortable period. In response to  policymaking steps from the incoming US administration, US bond yields started to rise alongside equity market falls. Advisers once again found that the ‘safe haven’ part of their portfolio did not necessarily protect clients’ assets. Fortunately, BNY Investments’ fixed income report found that advisers had already taken steps to prevent their clients from 2022-style falls.

The 2022 situation was a perfect storm. The MSCI World index dropped 17.7% in dollar terms in the calendar year 2022¹, while the Bloomberg Global Aggregate Bond index fell 16.2%². If that wasn’t bad enough, other ‘diversifying’ assets such as property and private equity also saw significant falls. The FTSE Nareit Equity REITs index fell 24.4%³, while the FTSE PE/VC index dropped 37.6%⁴.

There were a limited number of areas that defended capital over the period. Global infrastructure, for example, fared a little better – rising 4.7%⁵, but commodities and natural resources companies were the only real bright spot, as prices rocketed in expectations of global shortages when Russia invaded Ukraine. The average commodities and natural resources investment trust rose 7.3%⁶ over the year.

Correlation between equities and bonds had been rising for some time⁷. It’s just that advisers hadn’t noticed while investment returns were strong. It proved Warren Buffett’s famous statement: “It’s only when the tide goes out that you see who is swimming naked.”

It didn’t help that investors had gravitated to the longer-end of the yield curve. This was where the highest yields could be found in a low yield world. However, this was also the part of the market most correlated to equity markets – and particularly to the growth equities that dominated indices. The problem was most acute for passive investors. Often, their equity allocation was full of high growth equities, and their bond allocation full of long-dated bonds – in line with the skew in the major equity and bond indices.

However, active fixed income investors faced a different problem: they were often unsure whether their fixed income fund provided diversification or not. In 2022, the gap between the top and bottom strategic bond fund was 24.4%⁸ (2.4% to -22%). In other words, some funds did a good job in preserving capital and providing diversified returns, while others proved highly correlated to equity markets. This included some of the highest profile strategic bond funds.  However it wasn’t always easy for advisers to know which was which.

Shifting allocation

In our report, advisers said the main purposes of their fixed income holdings were (in order):

• Reducing overall portfolio volatility
• Offsetting equity market risk
• Protecting capital in market downturns

The expectation that fixed income will deliver protection during equity downturns is often a foundational assumption underpinning their financial decisions. Advisers increasingly recognise that they cannot take a chance on the diversification credentials of their fixed income allocation.

The risks around fixed income markets are not as acute today as they were in 2022. Investors are no longer coming from a 0% yield. Yields of 4-5% for developed market government bonds and 6-7% for corporate bonds offer the potential to cushion investors. Nevertheless, they need to be careful on duration if they want their strategic bond fund to protect them at times of inflation/interest rate-driven market volatility.

2022 has brought about a more nuanced understanding of diversification. An equity/bond allocation may work when market turmoil is driven by a normal economic cycle. Strong growth boosts equities, while higher interest rates depress bond prices and vice versa. However, when inflation expectations are high and unstable, bonds and equities may be correlated – they are both hurt by rising inflation and interest rates.

It is possible that the world economy is entering a period of structurally higher inflation. Deflationary forces, such as globalisation, or cheap Chinese imports, are ebbing, while trade wars, higher tariffs and spending on climate change mitigation are gathering momentum. If so, advisers will need to rethink their approach to diversification.

There are clear signs that advisers have taken this message on board. Our research showed strategic bond funds account for the highest allocation to fixed income (22%). The most popular reason for using a strategic bond fund is the manager’s ability to navigate changing interest rate environments (77%), followed by them being seen as a one-stop source of diversification across fixed income (38%).

So, strategic bond funds are seen as offering diversification, but advisers are worried about concentrations of bets. Indeed, 43% of respondents said concentration risk was a concern around selecting strategic bond funds, especially relating to if the manager view is incorrect. That points towards a desire for a more incremental approach that diversifies exposure to portfolio risks. 

Elsewhere, our research showed many saw the vulnerability of longer-dated bonds during the crisis and have shifted to higher short-duration exposure (22% of advisers adopted this approach following 2022 and 24% in the current environment). Shorter duration bonds are less sensitive to interest rates. As one adviser explained: “Shorter duration is more attractive because it is less exposed to volatility.”

Advisers also reported adding more cash or cash-like investments (20% in response to 2022, 19% under current conditions) and employing a more active approach (16% following 2022, 21% today). Under current market conditions, more frequent portfolio reviews have grown in importance (from 13% post-2022 to 18% today) as advisers look to check the balance of their portfolios and ensure they know what they’re holding.

It has also created more caution for some firms around passive strategies. Advisers now allocate 64% of their fixed income investments to active strategies. As one fund research house said: “I am not a fan of using passive in fixed income as I think you are buying the most indebted companies and countries”. This has also been a problem in the volatility since the start of this year – passive strategies inevitably hold a high weighting in the US. This has been a good option when it had the tailwind of dollar appreciation but has become more problematic as investors have cooled on US assets.

The legacy of 2022 is that a fixed income allocation is not enough, by itself, to provide diversification to equity market exposure and/or capital protection. Advisers are recognising that they need to be more selective about the type of fixed income they hold and when they hold it.

You can access the full report here: https://www.bny.com/investments/uk/en/advser/adviser-support/fixed-income-research.html

The value of investments can fall. Investors may not get back the amount invested. Income from investments may vary and is not guaranteed.

¹ https://www.msci.com/documents/10199/178e6643-6ae6-47b9-82be-e1fc565ededb

² https://curvo.eu/backtest/en/market-index/bloomberg-global-aggregate-bond?currency=eur

³ https://www.lseg.com/en/ftse-russell/indices/nareit

⁴ https://www.lseg.com/content/dam/ftse-russell/en_us/documents/factsheets/ftse-pevc-index-factsheet-december-2024.pdf

⁵ https://www.spglobal.com/spdji/en/indices/equity/sp-global-infrastructure-index/#overview

⁶ https://www.trustnet.com/fund/sectors/performance?universe=T

⁷ https://www.lseg.com/en/insights/ftse-russell/marriage-inconvenience-remarkable-harmony-between-stocks-and-bonds

⁸ https://www.trustnet.com/fund/price-performance/o/ia-unit-trusts-and-oeics?sector=O%3ASTERSRT&norisk=true&sortby=P11GBP_Y_24To36M&sortorder=desc&PageSize=25