• Early data shows strong interest in fixed income allocations as global return expectations rise
  • Flows into fixed income ETFs rose in late 2022, particularly into global bond ETFs
  • Unusual correlation between bonds and equities in 2022 set to end, benefiting balanced portfolios

 

After being out of fashion for much of the past decade, bonds are set to come back in vogue (along with the bob and lob haircut I’m considering) in 2023.

That’s the view of ETF issuer Vanguard which forecasts increased flows into bond ETFs in Q4 2022 are set to continue in 2023.

Vanguard believes rising interest rates and improved market outlook is set to bring bonds back to being an investment option of choice this year.

It’s been an interesting few years for the bond market, which largely fell out of fashion in the years following the Global Financial Crisis.

Investors tended to get a better yield on their cash rate in a bank than with a government or corporate bond.

Meanwhile, investors were also earning plenty of income from their share portfolios, encouraged by the dividend imputation regime that boosted the incentive for companies to pay out their earnings.

The Reserve Bank of Australia (RBA) said dividends paid by Australian listed companies have grown substantially since the GFC, most notably among large resource companies and the banks.

Vanguard’s Head of ETF Capital Markets Asia-Pacific Minh Tieu said flows into fixed income ETFs rose significantly in late 2022, particularly into global bond ETFs from $50 million in Q3 CY23 to $492 million in Q4.

Year on year domestic bond ETFs saw the highest increase in cash flows with 65%, recording $2.8 billion in 2022 compared to $1.7 billion in 2021.

“In 2023, our return expectations for fixed income have significantly increased compared to a year ago,” Tieu said.

“Thanks to higher starting interest rates as a result of central banks around the world working to quell persistent inflation, we forecast global bonds to return 3.9-4.9% and domestic bonds to return 3.7-4.7% over the next decade, a 2-percentage point increase.

“We saw the beginning of increased demand for fixed income ETFs in late 2022 and expect investor interest to grow as this new year unfolds.”

 

End to bonds and equities falling at once

Basic economic theory teaches there’s an inverse relationship in bonds and share markets.

When there’s prolonged price declines in equities, bond prices generally rise as investors seek a safe haven.

However, the latest market drawdown defied bonds 101 teaching with both bonds and equities falling simultaneously.

“The unusual correlation we saw between bonds and equities in 2022 is also set to end, delivering greater diversification benefits to balanced portfolio holders,” Tieu said.

He said while there was a lot of commentary about the death of the 60/40 portfolio with 60% of assets in equities and 40% in fixed income, there is likely to see a flip in sentiment this year as bond returns turn positive.

“The reason you have a balanced portfolio is generally equities and bonds go in opposite directions and diversify each other,” he said.

“But in last few years bonds and equities have been moving in the same direction which meant that the 60/40 portfolio didn’t make a lot of sense.

“However, we are coming out of that now so I expect to see a bit more of a return to the 60/40 portfolio.”
 

Diversity the key

According to Vanguard’s 2023 economic and market outlook, there’s a 40% chance of recession in Australia, notably lower than the 90% odds placed on the US, UK and Euro area.

He said ETF investors wondering where they should invest next should first and foremost consider their long-term goals, timeframe, and risk tolerance.

“Investors who are coming into the new year with concerns about recession might find solace in knowing that broadly diversified ETFs have proved resilient even in the face of economic uncertainty,” Tieu said.

He said market outlooks are useful to consider but they shouldn’t dramatically alter asset allocations but rather set realistic expectations and encourage healthy portfolio diversification.

“While we’ve maintained that history has proven the worth of balanced portfolios no matter the market conditions, the key takeaway for investors here is that sticking with a diversified asset allocation and avoiding the urge to time the market is the best way to achieve long-term investment success, no matter which asset class is predicted to outperform,” he said.