A bit more than a decade ago, 10-year Japanese Government Bond (JGB) yields were trading at just under 1.5 per cent, and I can recall having an argument with a group of financial advisers.

A lot of them asked why, when yields were so low, a portfolio manager would hold any JGBs at all. The JGB market was the second largest bond market in the world and having no JGBs at all was a very brave call for a bond investor to make, and would also have turned out to be a wrong call. From early 2002 to June 2003, JGB yields fell by a further 100 basis points to below 0.5 per cent, producing decent capital gains for JGB investors.

The point of remembering this period is not to suggest that the US is going the way of Japan, but rather to highlight that under certain scenarios, even what seem very low-yield government bonds can provide diversification benefits and decent returns.

This is particularly relevant today, when yields in a number of the world’s major government bond markets are trading at or close to all-time lows. Even here in Australia, 10-year yields are trading at around 3.2 per cent. That is higher than they were in July, when they reached a low of 2.7 per cent, but still very low historically.

Bond investors have enjoyed very solid returns in recent years, and diversified bond funds have attracted strong inflows. But given where yields are today, future bond returns are not likely to be anywhere near as strong as those we’ve seen in recent years. Moreover, it wouldn’t take much of a rise in bond yields to produce negative bond returns over the coming years.

Whither bonds?

With this in mind, do bonds still have a place in a diversified portfolio? The short answer is yes, and one of the main reasons harks back to my JGB story earlier. The future is inherently unknowable; there are a range of paths the world could take from here, and some of them are far from pretty.

For example, if the US were to join Europe in recession next year (which may happen if the current negotiations to avoid the fiscal cliff end up failing), then US treasury yields could fall even further. The point is that there are plausible scenarios where bonds will still provide diversification benefits.

From a risk-management point of view, having lower portfolio duration at this point seems to make sense. Skilled duration management can significantly reduce the risk of capital loss. In addition, having a preference for non-government bonds also makes sense as a way of enhancing yield, even though those securities have performed very strongly, and spreads over sovereign bonds have narrowed considerably.

In short, a well managed diversified bond portfolio should still hold its own as part of a diversified investment strategy.

Brian Parker is an investment strategist at MLC Investment Management