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In a rapidly evolving macroeconomic landscape, Australian investors are increasingly turning to global high grade government bonds as a highly defensive component of their investment portfolios. This move is predominately driven by global government bond markets offering greater portfolio diversity, enhanced return potential and broad sources of yield.

In this article, we unpack the key themes influencing investors' long-term views on the value of including global high-grade bonds into a fixed income portfolio.

Where are we now in the cycle?

The key question facing investors today is: Where are we in the current business cycle, and when will the next shift occur? A glance at the economic growth of the world's major economies and stock markets over the past decade reveals that we've been in an extended expansionary phase. However, determining exactly when the cycle will peak is notoriously difficult. While certain indicators have pointed to an approaching recession, accurately predicting this shift remains a challenge.

At a time where geopolitical tensions are intensifying and policy makers are grappling with softening global growth and persistent inflation, investors face a landscape of heightened uncertainty on many fronts.

Global central banks are embarking on a synchronized interest rate cutting cycle as the narrative has switched this year from inflation concerns to growth concerns. Global inflation has moderated from its peak levels, with current annual rates of inflation at 2.50% in the US (the lowest since February 2021), 2.00% in Canada, 2.20% in the UK, 2.20% in EU and 3.8% in Australia, although forecasted to fall to 2.70%. Meanwhile economic growth has started to show some cracks, which until now has been supported by government spending.

Employment remains a key determinant in the direction of growth and recent signs from the US indicate that this is turning. US employment data was recently sharply revised lower - which has triggered anxiety amongst central bankers. In response, they are eager to get on the front foot and curb labour market weakness before it deteriorates sharply. Savings are already getting depleted, and signs of rising delinquency are cautionary tales that will be exacerbated from job losses.

Asset allocations can be dynamically adjusted to optimise performance during different phases of the cycle. With the recent loss of US employment momentum, are we moving from Slowdown to Recession? If so, improving asset quality and liquidity will be important to navigate the coming market environment.

Chart 1: Phases in the business cycle.

The economic cycle consists of four key phases: Boom, Slowdown, Recession and Recovery, which then leads back to another Boom - continuing the cycle.

Expanding horizons: Unlocking enhanced alpha opportunities that may await

Not all bonds are created equal. High quality sovereign global bonds offer a lower risk profile due to their stability and creditworthiness. These bonds are typically issued by governments with strong financial standing, making them less susceptible to default and economic fluctuations compared to lower-rated or corporate bonds. As a result, they can serve as a safer option for investors seeking to mitigate risk within their portfolios.

Global high grade bonds currently present unique alpha opportunities for investors.

• Capitalising on the global interest rate cycle: With many G7 nations beginning to cut rates, increasing exposure to high grade government bonds can be advantageous. By extending the duration of high quality bonds during a period of falling interest rates, fixed income investors can achieve greater stability and lower credit risk. This strategy becomes far more attractive compared to newly issued bonds that offer lower yields in a low-interest rate environment.
• Highly liquid in all market conditions: The global bond market can play a pivotal role in an investor's portfolio due to its liquidity offering, with its ability to enter and exit positions to manage risk and changing market conditions. This flexibility allows fixed income investors to access their funds when needed, with a highly liquid bond market serving as a hedge against riskier assets during market volatility. Additionally, liquidity can present potential alpha opportunities, as investors can capitalise on market inefficiencies to enhance their returns.
• Lowering risk and volatility: Investing in a global bond portfolio reduces country-specific risk by spreading investments across multiple regions, mitigating the impact of economic or political challenges in any single area. It also provides access to different interest rate environments. Additionally, bonds from various regions often have lower correlation with domestic bonds or equities, helping to reduce overall portfolio volatility and improve stability.
• Optimising exposure through active management: By actively adjusting the duration of a bond portfolio, fund managers can respond to anticipated interest rate changes to maximise returns or minimise risk. They can also identify mispriced or undervalued bonds for enhanced yield opportunities and tactically allocate across different regions to capitalise on favourable economic conditions. Active managers employ risk management techniques to reduce downside risk and ensure liquidity by adjusting holdings based on market conditions, ultimately enhancing the overall performance of the portfolio.

Chart 2: Global Government Bonds Have Outperformed International Equities During Major Sell-Offs

Global government bonds are among the safest investments in an investor's portfolio, offering capital preservation and helping to reduce equity volatility due to their long-term negative correlation with stocks. They also provide stability to portfolios, especially during market downturns.

We can observe how global sovereign bonds perform during periods of financial market crises and significant events in the chart below. During the dot-com crash, the global financial crisis and European debt crisis, global government bonds outperformed equities providing capital preservation and a hedge against the equity market collapse. During the COVID-19 pandemic, global sovereign bonds and equities once again exhibited contrasting performances, although the dynamics were more complex than during previous crises. The pandemic caused a sharp, short-term market shock in early 2020, followed by an unprecedented recovery, largely driven by aggressive fiscal and monetary stimulus.

^{Source: JCB team analysis based on data from Bloomberg.
*CC JCB Global Bond Fund hedged to A$ (class A). Intl Shares are MSCI world ex Aus hedged to A$TR index.}

How should investors position fixed income portfolios as global rate cuts begin?

When considering the long-term value of fixed income, high grade bonds stand out as one of the safest investments in an investor's portfolio. Not only do they preserve capital but also help reduce equity volatility due to their long-term negative correlation with stocks, ultimately stabilising portfolios during tough market conditions.

We believe that now could be an ideal time to lock in elevated income levels and broaden fixed income portfolios to include a variety of global bonds.

The onset of the cutting cycle is likely to lead to a decrease in bank deposit rates, making government bonds a more attractive option for investors seeking capital appreciation. As a significant amount of dollars currently parked in money market funds is expected to flow into the government bond sector, this shift is further supported by the frothy nature of the private credit market, which has more than doubled in size since 2019. Interest rate cuts mean private credit's floating rate is less attractive, redirecting capital away from it into higher interest bearing assets. The transparency and liquidity of government bond funds provide a compelling argument for this reallocation.  

Adapting to market changes: why global sovereign bonds matter now

Falling interest rates signal a shifting investment landscape, presenting new opportunities for asset allocators. Rate cutting cycles underscore the importance of diversification, especially as economic conditions can change rapidly.