Fixed Income  

Bond investors warned of ‘lethal combination’ 

Bond investors warned of ‘lethal combination’ 

Industry figures have warned of the “lethal combination” affecting bond markets, but are split on whether investors should take shelter in bonds with a short maturity.

A sell-off in the British government bond market this month pushed the yield on 10-year gilts to double in the space of eight weeks.

Craig Inches, head of short rates and cash at Royal London Asset Management, said the yield on UK government bonds, particularly on longer-dated maturities, can head much higher.

While the government has hinted at fiscal stimulus to supplement monetary policy, a sharp fall in the value of the pound and the surging price of oil meaning much higher inflation is now on the cards.

Mr Inches said this is a “lethal combination” which means long dated issuance could increase in the face of rising inflation, while central banks are reluctant to either raise rates or buy bonds.

“This is a bleak outlook for owners of low-yielding conventional UK government bonds,” Mr Inches said, adding investors have only two options: “Think short, or think global.”

He said UK government bond investors worried by rising inflation should look internationally for opportunities, adding investors should switch UK assets overseas into assets such as US Treasuries, Australian and Canadian bonds.

These, he said, can offer attractive returns on a currency-hedged basis, thanks to a significantly higher yield. 

“For investors looking closer to home, we continue to believe that the best option is to try and shorten duration where possible, and seek protection in shorter-dated index linked assets.”

But Mike Riddell, bond fund manager at Allianz Global Investors, gave a counter view.

“A couple of months ago I was short-duration, particularly when it comes to the gilt market, because I thought UK government bonds looked very expensive.  

“The market was pricing in QE, but at the same time you had UK economic data which was the strongest it had been since January, so you had this big disconnect in what the market was saying and what was actually happening.

“It just got to the point where gilts started to become really expensive, so I reduced duration,” he said, adding he had not been short-duration since the day of the referendum result on 24 June. 

“But after the big sell-off over the last two months, and specifically the last 2 weeks, I think it’s now worth extending duration and having more interest rate risk. 

“I think, if anything, it’s more likely that bond yields will fall again.”

Mr Riddell runs two funds, the £1.1bn Allianz Gilt Yield fund and the £134m Allianz Strategic Bond fund.

The Allianz fund manager said the “very worst thing” for government bonds is more fiscal stimulus and an end to monetary stimulus, because it could mean government bond yields rise and the yield curve will steepen.  

This, he said, has accounted for a lot of the sell-off in the last few months in global government bonds.