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.
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 Quantitative easing policies are gradually being withdrawn, the US unemployment rate is at a 17-year low of 4.1 per cent, oil prices have been rising in recent months, and the dollar has begun to weaken notably.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.
Others point to technical reasons that could dampen the optimism over the US economy in the coming weeks. The Citi Economic Surprise index, a gauge of whether data releases are beating or missing expectations, has been negative in the second quarter for eight consecutive years, according to analysts at Nordea – chiefly because of seasonal factors affecting the evidence.
In advance of the second quarter of 2018, the data remains healthy enough. A 14 February release showed US inflation, which excludes food and energy prices, had risen at an annualised rate of 1.8 per cent as of December – slightly in advance of economists’ expectations.
Ripple effect
The latest bond sell-off has already had a more notable consequence than previous examples. In late 2016, rising yields were accompanied by a rallying equity market. But this time around the opposite happened: bonds and equities fell in tandem, a move more in keeping with the 2013 ‘taper tantrum’.
Elsewhere, the response has been more favourable for advisers. Intermediaries who have shunned government bonds continue to hold a plentiful amount of credit – that’s to say, corporate and high-yield bonds.
Despite nervousness over sovereign debt, fixed income funds enjoyed a record £14.3bn in net retail sales last year, with credit-heavy Strategic Bond funds accounting for £7.5bn of this amount alone. As Chart 2 shows, sales of Strategic funds were strong throughout the year.
It would have come as a relief to advisers that this riskier debt has not performed much worse than government bonds amid the recent slump.
“The moves in high-yield spreads are far lower in magnitude than the shifts in the equity market,” says James Bateman, CIO of multi-asset at Fidelity International.
Even the riskier end of the credit market performed relatively well compared with bonds with a higher credit rating, according to Royal London Asset Management. The firm suggests that BB-rated bonds – the highest rated high-yield debt – may have suffered because it was easier to sell than less-liquid CCC debt.
“The premium placed on liquidity is often overstated, as events in high-yield markets have proved, with more liquid bonds being disproportionately hit during the sell-off,” says Jonathan Platt, head of fixed income at the firm.
Other consequences
There is no doubt, however, that a sustained rise in bond yields would fundamentally alter the basis on which investments have been made over the past decade. Gam chief economist Larry Hathaway insists investors are “entering a new era” following a period of low growth, low inflation, and supportive monetary policy.
“[This] has strong implications for portfolio construction, [which] must become more attuned to fixed income risk. Equally, among equities allocations must be more selective,” he says.
Equity income investors, for example, have long been warned about the vulnerability of ‘bond proxy’ dividend payers. These shares, in sectors such as utilities and consumer staples, are perceived to move in tandem with fixed income yields. Equities in general may also look less attractive relative to bonds if the sell-off continues: investors anticipating this may be one reason why shares sold-off in February.
It is clear that economic events in the US have been the principle driver of recent fixed income moves. But UK gilt prices are not solely reacting to bond movements overseas; they are also factoring in the chance that UK interest rates may rise sooner and more sharply than expected. This was the explicit message delivered by the Bank of England (BoE) at its February meeting. It is not the first time such noises have been made, but the BoE’s credibility on this front may have been boosted by its decision to raise rates at the end of last year, and market participants now expect another hike to follow in May.
After years of rock-bottom rates, the sight of these changes – if they do happen – is bound to make some investors nervous. Strategists have been keen to stress the positives: they see this process of ‘normalisation’ as a sign the global economy is finally getting back on a healthier footing.
Sven Balzer, head of investment strategy at Coutts, says: “It is important to focus on the longer-term fundamentals and the health of the global economy, of which the US plays a dominant role.”
But after several years of surging markets set against a backdrop of sluggish economies, there is no certainty that improvements to the latter will be accompanied by rises for the former.
