It’s darkest before the dawn
The macro landscape suggests that bonds have lost their appeal as portfolio diversifiers. Should inflation and economic uncertainty persist over the next three months, a 60/40 portfolio might sustain further losses this year. The portfolio’s diversification benefits have slowly eroded over the last decade, culminating in the breakdown of uncorrelated equity and bond returns in 2022.
However, if we look beyond short-term market gyrations and volatility, there are reasons for optimism as the long-term outlook has improved recently.
Currently, market-implied expected returns over the next ten years are on average 2-3% higher than twelve months ago. This holds for both equities and fixed income assets and follows interest rate normalisation and repricing in equity markets.
Shifting tides of cross-asset risk premia
Since expected long-term nominal returns have been lifted across the board this year, it is worth examining the attractiveness of different asset classes on a relative basis. The expected term and equity premia have actually decreased, according to our analysis, whereas the expected credit premia for investment grade (IG) and high yield (HY) bonds have increased lately.
The expected term premium – defined as the difference between the US Treasury 10-year yield and the current cash rate – has slid about 70 basis points (bp) since September 2021. If we consider the expected cash rate over the next ten years as the proxy for the risk-free rate, then the expected change in the term premium would be around zero.
The expected equity and credit premia are calculated as the difference between the expected returns for the respective asset class (US equities, investment grade and high yield bonds) and the US Treasury 10-year yield.
Our findings indicate that the expected equity risk premium has decreased by 120bp, whereas the expected IG and HY credit premia have increased by 50bp and 100bp respectively (see chart).