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Niall McDermott's view on: Why Bonds are normal


Following a spell of overzealous enthusiasm for bonds in the opening months of 2023, Daniel Kahneman’s behavioural bias appeared to be in full effect, as investors ‘anchored’ their expectations for interest rates to the more recent low-yield environment we have seen since the Global Financial Crisis (GFC).

The year then saw investors reawakening to reality, as central bankers repeated their ‘higher for longer’ mantra and bond markets experienced a period of readjustment back towards more historically ‘normal’ levels. To navigate where we go from here, it is important to look at what insights we can glean from history.

The chart below shows US 10-year Treasury yields since the early 1980s. Interest rates in the early 80s had risen to double digits to tame the high inflation that took hold in the 70s. Then, as rising prices were brought under control, rates continued to trend lower for around the next 35 years.

Average 10-year Treasury yields since the 1980s

Source: Bloomberg

Economies were supported by ‘cheap’ money, as globalisation and technological change brought lower input costs, which held down prices. This meant that when trouble appeared – in the form of the dot-com crash, 9/11, the GFC, the European debt crisis and, more recently, the COVID-19 pandemic – central banks were confident that inflation was a thing of the past. They believed they could effectively throw money at economies with no consequences. Ultimately this led to a high-stimulus regime in the aftermath of the pandemic and, when signs began to emerge of inflation returning, the issue was dismissed as ‘transitory’.

The reality was different, however, as countries implemented different policy measures and economies opened at different speeds. This caused global divergences in growth which had been almost absent in the previous era of the ‘everything rally’, when interest rates had moved downwards together.

Now we are seeing a period of de-globalisation and it is clear inflation has not been defeated. In this environment it is vital to consider bond allocations carefully.

Whilst we believe bonds can once more fulfil their traditional role of providing stability, income and diversification, the interactions between return factors, as shown below, need to be managed carefully.

Key factors driving bond returns

If we believe we have now reached the end of the rate-hiking cycle, then the question changes from ‘how high will rates go?’ to ‘how long will rates remain high?’. Which economy will cut rates first is uncertain at this stage, with a wide range of different views being offered on the outlook for 2024. This uncertainty and the wide range of potential outcomes underlines the value of investors taking a global approach to their bond allocation, to provide access to the broadest range of opportunities and maximise diversification benefits.

Capital is at risk. The value and income from investments can go down as well as up and are not guaranteed. An investor may get back significantly less than they invest. Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds.