Monetary Policy  

Managers divided as bond valuations begin to diverge

Managers divided as bond valuations begin to diverge
 UK gilts’ outperformance steps up

Fund managers are split over whether a disconnect between bond prices in the US and other regions will disappear quickly – or if it represents a new opportunity for investors to dodge a fixed income-wide sell-off.

US Treasury yields have risen sharply in recent weeks as markets price in another Fed rate hike this Wednesday and a further tightening of monetary policy in the months ahead.

But in a departure from recent convention, UK gilt yields have not followed US rates higher this year. In Europe, meanwhile, short-dated yields have been hitting record lows as a result of the European Central Bank’s (ECB) bond-buying programme.

UK 10-year gilt yields have fallen from 1.5 per cent to 1.2 per cent since the end of January, a period in which US Treasury yields have risen from 2.5 per cent to 2.6 per cent. The divergence between long-dated bonds has been even more marked.

Some managers believe the discrepancy will be short-lived despite rate hikes being off the agenda in the UK.

“If you typically look at the UK market, over its life, it will follow the US and Europe,” said Royal London Asset Management’s head of short rates Craig Inches. “Even though we know we have massive inflation coming, the long end is still sitting at sub-2 per cent.”

Others, however, have pointed to trends such as institutional buying in the UK and ECB influence in Europe as meaning the discrepancy could continue.

Henderson fund manager James de Bunsen, who added to gilts around the turn of the year when prices were falling in tandem with the US, said: “As much as no one really likes holding gilts, they can and do tend to give you a nice, uncorrelated return if there is risk aversion. It’s a valuation thing and a portfolio construction thing.”

But Mark Holman, chief executive of bond boutique TwentyFour Asset Management, suggested the state of play in fixed income markets meant bonds may not provide the expected protection in the event of a sell-off in riskier assets.

“We have come to that point again when the risk-off portions of fixed income portfolios may present us with much unwanted mark-to-market risk,” he said. “Correlations [are] vulnerable to a period of decoupling.”

He added that TwentyFour’s “risk-free” allocations were now being positioned in ultra-short government bonds, cash and Australian sovereign debt.

A similar sentiment can be seen among other managers. Jupiter’s Ariel Bezalel has over 11 per cent in Australian government bonds in his £3.5bn Strategic Bond fund.

Mr Inches said his team had taken an alternative approach. It sold a five-year gilt position in favour of an inflation-linked five-year US Treasury bond, and hedged the currency. He suggested the spread between US and UK debt could widen another 0.2 percentage points before the trade would become unprofitable.

“You could have another rate rise priced in, hold that trade for a year and be onside. Even taking into account the currency, the US is still a reasonable investment universe compared with the UK.”