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3 Reasons to Like Bonds

What we see in this low-yield environment.

Holly Black: Welcome to Morningstar. I'm Holly Black. With me is Mark Preskett. He is a portfolio manager at Morningstar Investment Management.

Hello.

Mark Preskett: Hi.

Black: Mark, you look at the whole investment spectrum in your role, but I think a really interesting area this year is fixed income and bonds. Do you want to just talk us through reasons you like bonds and the role you see them playing in an investment portfolio? What's the first reason to like a bond?

Preskett: Absolutely. So, I think even though we're in a very low-yield environment, we've seen what's happened in bond markets over the last six months, but they still continue to provide investors with diversification in times of market stress, and there is still, in our view, a place in portfolios for high-quality government bonds, and they fulfill that role of safe-haven assets. Things like QE, low interest rates employed by central banks, has meant those yields are at all-time lows, and we would fully expect future returns to be lower than in the past, but there's still exceptionally strong demand for these assets. Insurance companies, pension funds, there's regulatory reasons for holding bonds. And when we look at things like auction data and syndication data from the Bank of England, say, every issue is significantly oversubscribed. So, for us, this safe-haven status of government bonds is clear.

Black: So, bonds are a safe haven. Why else do we like bonds?

Preskett: Well, that's the government side from developed markets. It's obviously very different when it comes to credit assets. We saw spreads and prices fall, spread widen in March to a very significant degree. And there's been a rally pretty hard since then, but there are still areas of that, pockets of the credit market, that are offering attractive yields. And like the equity market, there's been very significant sector divergence within credit. And for those willing to do the work, there are some good opportunities to lock in high-single-digit yields, especially from sectors like financials and some energy-related names. It's definitely clear that the corporate and high-yield bonds are not as cheap as they were, but we still like this part of the market. And that central bank support through direct purchases is providing a backstop to any material fall in prices going forward.

Black: So, the clue is in the name there. "Fixed income"--a reason to like it is the income. So, what's one final reason that we like bonds?

Preskett: It's slightly more nuanced this, but if you look back in history, the idea of investing for real yields has been a very successful investment strategy--i.e., you buy a government bond that offers yield in excess of its domestic inflation rates. So, if you think of the UK having an inflation target of 2%, 2.5%, 2.2%, say, our yields are negative on a real yield basis. We've got a 10-year yield of 80 basis points at the time of making this video. So, among the DM world, there isn't really very many positive real yields out there. But if you look at elsewhere into the emerging markets, you can actually see that there's parts of that market offering real value.

We've seen central banks in the emerging markets acting reasonably sensible in this crisis. Typically, in a longer crisis, they've sought to protect their currencies by raising rates in the face of falling economic growth or weakening of data. This time around, by and large, they did the right thing and cut rates. Their currencies did fall, but it means that a lot of the bond markets are offering pretty good positive real yields, and we are overweight emerging market, local and hard currency, so bonds issued in the local currency and bonds issued in dollars. The local-currency market, in particular, because their currencies have performed pretty badly this year, pretty poorly this year, is another kicker there for the long-term investor. So, it doesn't come without risks. It is at the riskier end of the bond market, but emerging market does look quite attractive for us at this moment.

Black: Mark, thank you so much for your time. For Morningstar, I'm Holly Black.

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