Bonds have not become a perfect diversifier again in every environment, but they are in a much stronger position to play that role than they were a few years ago.
The inflation shock of 2022 showed clearly that when inflation is the dominant risk driver, equities and bonds can struggle at the same time.
But Craig Veysey, fixed income lead at Guinness Global Investors, says today’s starting point is different.
Higher starting yields provide a much more meaningful income cushion against price volatility and modest yield increases.
“That matters because it means investors are being paid more to hold duration than they were in the near-zero-rate era,” Veysey says.
“At the same time, as the macro backdrop becomes less dominated by inflation alone and more influenced by growth risk and recession probability, the conditions for bonds to act as a genuine portfolio stabiliser are more plausible than they were in 2022.”
Diversity in diversification
The key caveat, however, is that not all bonds diversify equally, so portfolio managers must pay attention to the types of credit, as well as geography and duration.
Veysey explains that core developed government bond markets can still provide strong diversification, particularly when starting yields are already attractive, while longer-duration bonds can offer significant upside in a genuine risk-off move if yields fall from elevated levels.
Higher-quality corporate bonds can also act as a useful diversifier, provided spreads are wide enough to compensate for the credit risk.
“By contrast, as you move down the credit scale, lower quality and more cyclical bonds are much more influenced by the economic cycle and can behave in a more equity-like way, particularly when credit spreads are tight,” Veysey adds.
Case for global bond exposure
At Evelyn Partners, Dan Caps, lead portfolio manager of the Index MPS range, says they have a global outlook for their fixed interest portfolios, with US treasuries in particular always having a big role to play.
Despite concerns around the US deficit, Caps says T-bills are still vital safe haven assets.
He explains: “With credit exposure, global allocations allow us to access different yield curves and interest rate environments.
“However, whenever we look beyond sterling issues, whether this is in credit or sovereign issues, we prefer to hedge our currency exposure to maintain the relatively low volatility characteristics of the asset class.”
While portfolios can be too UK-centric, both in fixed interest and equities, Caps says that current yields on gilts and UK corporates are still attractive relative to other developed markets.
He adds: “In the current conditions, there is some argument in maintaining a reasonable degree of exposure to sterling-denominated fixed interest.”
Stronger fundamentals in EM
When it comes to the investment case for emerging market debt, Carlos Carranza, a fund manager at M&G, notes that a great deal has changed across emerging markets over the past decade, with many countries building substantial resilience buffers that are now increasingly evident.
EM central banks in particular have demonstrated exceptional monetary policy discipline and have maintained historically high real policy rates, which helps insulate currencies from external shocks.
“For example, average real rates in EM were around -3 per cent in 2022, during the height of the global inflation shock,” Carranza says.
“Today, real rates have shifted to roughly +3 per cent, so a 6 percentage point increase, reflecting a decisive and proactive policy stance.”
This improvement is also visible in recent central bank actions.
In Brazil, the central bank opted for a modest 25bp rate cut at its latest meeting, citing rising global risks.
Chile shifted to a more cautious stance, pausing earlier dovish guidance.
Meanwhile, Hungary kept its policy rate unchanged at 6.25 per cent, highlighting inflation risks stemming from geopolitical tensions.
Carranza says these examples underscore a broader trend of EM monetary authorities acting swiftly, independently and prudently to manage inflation expectations and reinforce macroeconomic stability, which favours investments diversifying away from the USD.
Several EM countries have also been steadily improving their fiscal credibility, particularly when compared with developed markets.
Carranza says a review of fiscal trends over the past 20 years shows a clear relative strengthening in EM fundamentals.
Since 2005, EM fiscal deficits have risen by only about 16 percentage points, a modest increase when compared with the 57 percentage point surge in US debt‑to‑GDP, which has nearly doubled over the same period.
Additionally, debt to GDP for EM investment-grade countries has increased by a modest 9 percentage points, reflecting efforts in fiscal management, and decoupling further from developed markets.
The factors differentiating resilient EM economies from vulnerable ones include the following:
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Fiscal dynamics play a critical role. Investors are scrutinising government spending more closely than ever, viewing fiscal discipline as a key driver of market performance and medium‑term sustainability.
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Monetary policy credibility is essential. Investors look for central banks with sufficient policy rate buffers, the ability to respond swiftly to internal or external shocks, and the independence to manage inflation expectations effectively.
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Political and institutional stability remains a core area of focus. Strong institutions, transparent governance, and predictable policy frameworks help anchor investor confidence.
But investors remain structurally under allocated to EM fixed income, leaving substantial room for growth across the asset class, according to Carranza.
He says: “One way to illustrate this is by examining the share of local sovereign bonds held by international investors.
“The latest available data shows that foreign participation stands at just 15.4 per cent of the outstanding local sovereign debt stock, well below pre‑Covid levels, when it consistently exceeded 20 per cent.”
He notes this subdued participation indicates that international positioning in EM debt is still relatively light, suggesting meaningful capacity for additional foreign inflows.
“The opportunity is particularly compelling for investors seeking to diversify away from potentially concentrated USD‑denominated exposures and broaden their global fixed income allocations.”
Ima Jackson-Obot is deputy features editor at FT Adviser