The rise in interest rates over the past two years has been a reminder to many that government bonds can once again provide a yield.

This is why, according to Ben Kumar, head of equity strategy at 7IM, many discretionary fund managers have steadily been increasing their allocation to government bonds – evident in the data we at Asset Allocator collect on DFMs

Kumar adds: “Like most other DFMs, we have been increasing our allocation to government bonds over the last two years, from an extreme underweight at the start of 2023 to now, a reasonably significant overweight. 

“[This is because] you're getting paid a yield. And we know that [in a] recession, or if there is some trouble, or if interest rates get cut, you will make a decent capital return.”

James Burns, lead manager of the Evelyn Partners active managed portfolio service, which has been increasing sovereign bonds over corporate bonds, says: "Credit spreads are relatively tight. And our view is if we did have a sort of growth shock, the extra spread you're getting paid for the corporate bonds isn't really worth it because they aren't going to protect in the same way that government bonds should in a downtown."

At Abrdn, Sam Buckingham, an investment manager on the MPS team, says while their approach has not fundamentally changed, they have made adjustments that have impacted both their long-term and short-term bond allocations.

Long-term changes resulted from a periodic strategic asset allocation (SAA) review last year, where Abrdn recalibrated the long-term exposures of portfolios with updated asset class return estimates. 

Changes to the SAA for each risk level are nuanced, but one of the themes across all risk levels was an increase in bond allocations. 

Buckingham adds: “With bond yields at much higher levels than they had been for many years the long-term expected return has also risen, and we wanted the MPS to reflect this drastic shift. 

“Within bond allocations, our updated SAA also resulted in diversifying government bond exposure geographically, reducing the UK proportion in favour of global.”

In late 2022 Abrdn shifted from underweight in government bonds to overweight, with a preference for US over UK, with the former yield trading well above the latter. 

In May last year, after US government bonds materially outperformed those in the UK, Abrdn sold the off-benchmark US position to switch into the UK, as US yields were now trading below the UK. 

More recently, in October, after bond yields shifted a leg up, Abrdn increased its government bonds overweight by adding to US and global government bonds.

This move, Buckingham says, was funded from going underweight global high-yield corporate bonds, which he says are expensive considering the outlook that a recession is likely. 

Like Abrdn, many DFMs have been applying some caution to high yield.

7IM's Kumar says: “If everyone had to relearn that rates can go up as well as down, they're also going to have to relearn that lending standards are something you do need to take seriously. 

“In investment-grade corporate bonds, it's not too much trouble. Most of the investment-grade issuers out there are big, huge global companies [that] are extremely well financed. The thing that will be interesting is in the more speculative areas of the fixed income market.”

Meanwhile, Buckingham says: “We judge whether corporate bonds – both investment grade and high yield – are expensive by assessing the additional yield you receive above a government bond with the same maturity – known as a ‘credit spread’.

“In times of economic stress, you should receive a higher credit spread to compensate for the increased risk of defaults. Credit spreads for high-yield bonds are low by historical standards – particularly in the US – hence why we believe high yield is expensive.”

With increased allocations to government bonds, DFMs say the biggest determinant of returns from fixed income allocation over the past year has been duration and interest rates.

Evangelos Assimakos, investment director at Rathbones Investment Management, says that over the past year default rates have remained low by historic standards, so the credit rating of a bond has not been the critical differentiator for a bond’s return. 

Assimakos adds: “All else being the same in one’s bond allocation, it’s been much better to hold shorter-dated bonds versus longer-dated ones. This is because interest rates had been rising to combat high levels of inflation; the two greatest enemies of a fixed income investment.”

Buckingham adds: “If we saw yields continue to fall meaningfully lower this year then we might reduce our exposure, but this would depend on how the economic backdrop develops, ie what caused the movement in yields. 

“Within government bonds we may look to switch exposure between UK and US, where the spread between the two has moved around substantially. We have added value by taking advantage of these swings and continue to look for opportunities to do the same.”

Iain Stealey, manager of the JPM Global Bond Opportunities fund and international chief investment officer for global fixed income, currency and commodities, has added modestly to investment-grade corporate bonds over the course of the past year.

He said: "In a soft-landing scenario (our central case), rather than adding pure government bond exposure, we lean toward investment grade corporate credit. Corporate fundamentals are in a good place: companies are not over leveraged, and we expect earnings to remain relatively resilient. We should acknowledge that average spreads are quite tight relative to history, but this is not unusual.

"We do see strategic opportunity in developed market core government bonds, where yields are now significantly higher than 20-year medians. Europe in particular looks attractive, given the softer growth picture there. Regardless of the timing and magnitude of central bank cuts, government bonds once again offer what they were always meant to: a healthy income, and diversification via capital appreciation in the case of an economic downturn."

But with investment-grade credit and high yield, caution remains among portfolio managers.

Assimakos says: “In IG we start the year with only modest allocations, as we do not perceive a significant premium available for the additional risk taken versus government bonds. 

“Equally, we are not impressed by the returns currently available from high-yield bonds, where we would anticipate default rates to pick up during the course of 2024.

Abrdn’s Buckingham adds: “Our allocation to high-yield bonds – where we are underweight – may change depending on market movements and the development of the global economy.

“The rise in interest rates and changes in interest rate expectations has been the key driver of fixed income returns. For example, at the start of 2023 the market priced US interest rates to be just over 4.6 per cent by the end of 2023. 

“The year ended with US interest rates at 5.5 per cent as inflation proved stickier and more broad-based than predicted. This unexpected development saw yields rise and bond prices fall accordingly.”

In recent months the phenomenon [of high interest rates and inflation] has started to shift, as interest rates seem to have peaked.

“And inflation has been on the retreat,” Assimakos adds. “As a result, more recently, longer-duration bonds have held the upper hand in terms of returns.”

Peter Dalgliesh, chief investment officer at Parmenion, says: “In the fourth quarter of 2023, expectations of a peak in interest rates led to yields falling meaningfully in 10-year gilts and Treasuries and generating strong positive returns for investors.”

Looking ahead to 2024, government bonds remain attractive to DFMs as yields at current levels offer an attractive return profile and portfolio protection in the event of a recession – despite bond yields falling quite significantly in Q4 2023.