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PIMCO: What's Happening to Bonds and Why?


History will regard the ongoing phase of dislocations as a transitional period of adjustment triggered by changing expectations about policy, the economy, and asset preferences.

To say that bonds are under pressure would be an understatement. Over the last few months, sentiment about fixed income has flipped dramatically from a favored investment destination that is deemed to benefit from exceptional support from central banks, to an asset class experiencing large outflows, negative returns, and reduced standing as an anchor of a well-diversified asset allocation. Understanding well what created this change is critical to how investors may think about the future, including the role of fixed income as part of prudent investment portfolios that help generate returns and mitigate risk.

Tailwinds to headwinds

To illustrate the rapid changes in perceptions, consider where fixed income stood just a few months ago (at the end of April, to be exact).
A diversified portfolio of high quality bonds, as defined by the widely followed Barclays US Aggregate benchmark, had delivered strong returns over the last 20 years (Figure 1). The 1-year, 3-year and 5-year annualized returns stood at 3.6%, 5.4% and 5.6% respectively. For the 10-year period, it had generated an annualized return of 5.0%.

In addition to delivering solid returns with lower volatility relative to stocks, the inclusion of fixed income in diversified asset allocations had also helped to reduce overall portfolio risk, including through generally negative correlations of returns of Barclays US Aggregate and US Treasury indexes with S&P 500 (INDEXSP:.INX). Diversification was particularly beneficial in the last 15 years (Figure 2).

The combination of return generation and risk diversification was part of a broader virtuous circle for fixed income, which also included significant inflows to the asset class and direct support from central banks.

As an example, between Q1 1998 and Q1 2013, fixed income assets held by households and pension funds increased from $4.7 trillion to $12.1 trillion. Accordingly, their share in the market value of financial securities of US households and pension funds rose to some 35%.
The asset class was also helped by exceptional policy support from the Federal Reserve Bank. This served to both bolster returns and suppress volatility.
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