Bond funds could be in for a world of pain in 2021 if government bond yields continue to rise and the yield curve steepens says Fidelity International director and cross-asset specialist Anthony Doyle.

In an interview with Morningstar, Doyle says rising inflation expectations this year could hamper the value of bond prices, with longer dated bonds most at risk.

Inflation erodes the purchasing power of future income. Long duration bonds are especially vulnerable because the coupon payments stretch years, sometimes decades into the future. Faced with higher inflation expectations, investors will typically sell long-dated bonds, driving down prices and increasing yields.

“In a rising yield environment, investors will generally want to be positioned short interest rate duration to protect their portfolios from higher yields and thus lower bond prices," he says.

“Long-duration assets, like government bonds, will suffer the most as yields increase."

Doyle adds that since 2008, bond indexes across the government, investment grade and high yield markets have generally lengthened in duration.

“Consequently, the income cushion that investors have historically received has narrowed, leaving them more susceptible to capital volatility and total return losses…" he says.

"Of course, there are some parts of the bond market that generally perform well as economic growth picks up and default rates fall, particularly investment grade and high yield corporate bonds."

Bond yields have risen in response to rising expectations of inflation, aided by an improved economic outlook with the rollout of covid-19 vaccines and fiscal stimulus worldwide. Much of the rise in sovereign yields since late 2020 reflects rising inflation expectations.

Morningstar director, fixed income strategies Tim Wong says this could reverse the bond price gains of 2020, when interest rates fell to historical levels, pushing up bond prices. That enabled active bond funds to finish well ahead of passive market indexes over the full year.

“The bulk of active bond managers ended up outperforming their respective indexes over the full course of 2020," he says.

"This is commendable. At the same time, this feat isn’t immune to criticism. Namely, many active fixed interest strategies struggled when investors were clamouring for a source of portfolio defence and liquidity [in March 2020]."

“It took enormous support by policy makers and central banks for bond markets to resume functioning more normally, setting the stage for many active managers to outperform alongside the eye-popping rebound witnessed in equity markets.”

Reserve bank

According to Wong, dwindling risk aversion saw credit spreads compress dramatically from 24 March until 31 December 2020, benefiting existing investors as bond prices rose.

“Several active managers also amped up exposure to credit during the second quarter of 2020 to capitalise on the valuations on offer and issuance that followed," he says.

"This included (but was not limited to) the likes of Janus Henderson Australian Fixed Interest (5666), AMP Capital Australian Bond (16869), Schroder Fixed Income (10862), and Legg Mason Brandywine Global Opportunistic Fixed Income (16192)." 

Passive at risk

Wong warns that rising bond yields could hit passive bond funds harder than active strategies as they tend to hold more longer dated government bonds.

“The defining trait of many passive vehicles is their sizable government-related bond exposure and lengthy duration," he says. "We are under no illusions about the pain rising and steepening yield curves can wreak on this stance.

Anshula Venkataraman, senior investment analyst with Crestone Wealth Management, adds that active managers can increase short-duration bond positions in a rising rate environment, but passive strategies that track benchmark indexes don’t have that flexibility. 

“The ability to be tactical around bursts in volatility is where active bond funds differentiate themselves; therefore, volatility will be beneficial for some and detrimental to others," she says.

"They have the ability to utilise a number of levers including active interest rate management, inflation linked and credit; all elements that have been key to navigating the current environment.”

However, Stephen Miller, GSFM investment strategist, says varying the duration of bonds also depends on the extent to which investment guidelines allow bond managers to manipulate their exposures.

“Anecdotally, it is rare for managers, to manipulate their duration exposures by any more than 1.5 years away from their benchmarks,” he says.

Most conventional bond funds – whether active or passive – are benchmarked against an index of bonds that have a duration of somewhere between a little over five years (for a domestic index) to a bit over seven years (for a global index).

“If a bond fund has a duration of say five years that will mean that a 1 percentage point increase in bond yields will result in a ‘once and for all’ 5 per cent reduction in the net asset value of the fund," Miller adds.

"However, there are bond funds that that are not benchmarked to bond indices with defined durations.

“These are ‘absolute return’ or ‘unconstrained’ bond funds that typically have much lower duration than conventional bond funds and generally have a more diverse set of strategies.

"They do, however, mostly retain the same ‘low volatility’ return profile as bond funds.

"These funds tend to outperform conventional bond funds in times of significant increases in bond yields."

Whether bond yield continue to rise isn’t certain. Venkataraman says the longer end of the curve has seen yield rise around 100 basis points since the lows in the fourth quarter of 2020, steepening the bond curve to historic highs. But she doesn’t expect bond prices to fall much further:

“We believe a significant amount of the pick-up in actual and expected inflation over the next few months has already been reflected in steeper curves," she says.

"While there remains some room for longer dated yields to drift higher or overshoot further in the months ahead, we expect any sell-off to be much less material than that occurring through early 2021.”