Bond investors fret that this time it's different

Bond investors fret that this time it's different

When it comes to government bonds, few could accuse advisers of being behind the curve. For years now, many have shunned the asset class in anticipation of a major correction.

As yields fell to record low upon record low, the not-unreasonable assumption was that this state of affairs was unsustainable. And yet the 30-year bull market for fixed income has proved resilient: UK gilt funds have returned a healthy 13 per cent over the past three years and 22 per cent over five.

There have been slumps along the way, most notably in the second half of 2016, when the ‘reflation trade’ saw the sector fall by an average of 11 per cent in just six months. But a sizeable chunk of those losses was made up in 2017 as doubts grew over the return of inflation.

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The sell-off has returned with a vengeance at the start of this year. Renewed suspicions that inflation may break out in the US have pushed up bond yields once more. Ten-year US Treasury yields have moved from 2.4 per cent to 2.9 per cent, a four-year high, and this move has had a knock-on effect on other government bonds.

Ten-year gilt yields, for example, have risen to 1.6 per cent – the highest level since early 2016 – equating to a 4 per cent year-to-date loss for UK gilt funds. Chart 1 puts these portfolios’ loss into context, but it is not surprising that the bond bears are again claiming vindication. They claim that tax cuts across the Atlantic are translating into long-awaited wage increases that will push up inflation.

Pluses and minuses

How realistic is this theory? Predictions that core inflation is returning have been dashed numerous times over the past decade, but some factors are more supportive this time. Quantitative easing policies are gradually being withdrawn, the US unemployment rate is at a 17-year low of 4.1 per cent, oil prices have been rising in recent months, and the dollar has begun to weaken notably.

Chris Iggo, chief investment officer (CIO) of fixed income at Axa Investment Managers, says: “I genuinely think that this time is different. There is no ‘buy on dip’ mentality in the bond market at the moment; there is more of a ‘sell on strength’ approach. That can change quickly, but it also means the risk is to yields going higher.” 

Countering this are the arguments that jobless figures do not include the many millions who have given up looking for work, as well as the view that bond markets may have already factored in the currency and commodity effects.

Pimco, the world’s largest bond manager, is not an entirely impartial observer of this debate. It appears to now sit in the second camp nonetheless. “While we acknowledge the improving economy, inflation in the US is picking up but it’s doing it very gradually,” global credit CIO Mark Kiesel told the Financial Times on 18 February. The firm thinks 10-year Treasury yields will go little higher than 3 per cent before buyers return.