What does the recent pick up mean for bond investors?

One of the reasons why economic news can sound gloomier than it needs to is that the traditional employers of most financial talking heads are fixed income and money market departments.

There are important exceptions.

Corporate bonds are partly driven by issuers’ creditworthiness, so their prices go up less when the economy weakens because credit quality falls with it.

The same is true of some governments’ bonds, for similar reasons.

More importantly, when falling interest rates reflect lower inflation, or a secular reassessment of real borrowing costs, bond prices can rise – and yields fall – even as economies grow.

We’ve seen this often during the 30-year bull market in bonds that has followed the awful inflation – and sky-high interest rates – of the seventies.

Indeed, bonds have done such a good job of protecting and growing wealth in this period, that we suspect many private investors have come to view their bonds as trusted family retainers to be cherished to maturity rather than put out to grass.

Nonetheless, a stronger economy – and more job creation – is more likely to nudge bond yields higher, and prices lower.

This is what is driving the normalisation of interest rates that lies ahead.

The latest batch of data – even net of the most recent lagging US jobs report – suggests that economic activity has indeed picked up on both sides of the Atlantic, most visibly, and unusually, in the UK.

This is why bond prices were again falling recently, and forward interest rates rising (in the latter case, in spite of the misplaced efforts of the central bankers to ‘guide’ them back down).

US and UK 10-year bond yields have already doubled from last year’s lows, and have almost done so in Germany.

But at 3 per cent, 3 per cent and 2 per cent respectively, they remain below the likely trends in nominal GDP growth, and what has long been thought of as ‘fair value’.

Conversely, while developed stock prices have risen a long way, they continue to look inexpensive (stocks’ ‘fair value’ has little to do with cyclically adjusted price-to-earnings and Q ratios, which are even more flawed than conventional valuation metrics).

Not everyone shares the mood about the US economy’s ability to shoulder the higher mortgage rates that recovery will bring, or about stock valuations, and markets may grow nervous again in the weeks ahead.

Meanwhile, as the G20 and the United Nations come to terms with events in Syria, bonds may appeal as safe havens for a while.

Looking beyond short-term volatility, portfolios should mostly be aligned with what’s best for people and business.

One says ‘mostly’, because emerging markets could be hit by further portfolio outflows as Western monetary conditions normalise.

They are now cheaper, and some advocates have backtracked: much bad news is indeed in the price.

Even so, emerging markets may remain vulnerable until developed yield curves have steepened still further.

Kevin Gardiner is chief investment officer of Europe at Barclays Wealth and Investment Management

Benefits and risks: what to watch out for

Hilary Coghill, chief investment officer, highlights the pros and cons for the fixed income asset class in the current market environment:

Positives

• S&P upgraded the US sovereign credit outlook to stable from negative

• Bank of England governor, Mark Carney gave an indication that UK interest rates will continue to remain low

• UK CPI fell to 2.8 per cent in July from 2.9 per cent in June and the RPI fell to 3.1 per cent from 3.3 per cent

Negatives

• While US treasuries are less expensive than they were a few months ago, the suggestion that the FOMC will begin tapering this month, suggests they are likely to remain weak, and a further sell-off may be experienced

• Bond market liquidity remains difficult and has been exacerbated by a recent lack of issuance and large outflows from mutual funds

• Emerging market debt, particularly local currency, looks set for further retrenchment as investors move to perceived safe havens