Taking cover in government bonds ahead of a recession? BlackRock says that's now an 'obsolete' strategy

Published Wed, Oct 19 20228:31 PM EDTUpdated Wed, Oct 19 202210:36 PM EDT

One important part of the recession playbook is "obsolete" — and that's seeking shelter in bonds, according to BlackRock, the world's largest asset manager. "Recession fears are roiling markets. Investors traditionally take cover in sovereign bonds, but we see this recession playbook as obsolete," strategists from BlackRock Investment Institute, led by Jean Boivin, wrote in a note earlier this week. Central banks have been hiking interest rates to control inflation, "causing recessions" in the process. But they haven't been cutting rates like they typically do in recessions because of how persistent inflation has been, BlackRock said. In addition, BlackRock expects investors to "demand more compensation for the risk of holding government bonds amid high debt loads." That's why the firm is of the view that Treasurys are less attractive right now. "We're underweight government bonds because yields have room to move higher, and we don't think they can be a safe haven when recession comes," BlackRock wrote. Bond yields move inversely to prices. Interest rates would need to hold steady or fall for Treasury returns to turn positive, the firm added. 'Bond vigilantes are back' Long-term yields are rising across developing markets as a result of tighter monetary policy, inflation and debt, BlackRock said. "Central banks in the new regime face a sharper trade-off between growth and inflation than in the past," the firm's strategists wrote. "We think central banks will eventually halt rate hikes. But they won't have done enough to get inflation all the way back down to target, implying they won't be able to start easing policy, in our view." Higher rates and inflation will create a "ripe environment" for investors to demand higher term premiums for long-term bonds, BlackRock said. A term premium is the amount by which the yield on a long-term bond is greater than the yield on shorter-term bonds — reflecting the amount investors expect to be compensated for lending for longer periods. "All of this underscores why the old recession safe-haven playbook doesn't apply," the firm wrote. "That's no mere musing: We see it playing out in the UK in real time." BlackRock cited the recent crisis in the U.K. and its central bank's ensuing plan to buy bonds. The U.K. government had announced a radical economic plan — a so-called "mini budget" which included unfunded tax cuts — on Sept. 23. The move sent financial markets into a tailspin , as investors ditched U.K. bonds and sold off the pound. In a bid to stem the sell-off, the Bank of England in late September said it would delay its plan to sell U.K. government bonds and buy long-dated bonds for two weeks as part of emergency measures to calm the market. The bond-buying program ended last week, but yields spiked anew after, BlackRock noted. The sell-off may not ease, with "bond vigilantes" returning, the asset manager said. The term refers to bond traders who threaten to or actually sell a large amount of bonds to signal their protest with the issuer. "In this environment, bond vigilantes are back and heralding term premium's return," BlackRock said. "The upshot: We're broadly underweight government bonds. U.S. bond returns are the most positively correlated to stocks in two decades on a 90-day rolling basis. We expect that correlation to stay positive, erasing bonds' role as portfolio diversifiers," it added. Additionally, higher short-term bond yields are making long-dated bonds less attractive as investors can get decent returns for the former with less interest rate risk, the firm added. The yield on 2-year U.S. Treasurys surged recently, in tandem with the U.S. Federal Reserve's rate hikes. It has since stayed elevated at 4.45%. What to buy Investors still looking to buy bonds should prefer inflation-linked ones as they are "not pricing in persistent inflation," BlackRock said. The asset manager also likes high quality credit — strong corporate balance sheets should limit default risks even in a recession, it said.