Global inflation rates and bond yields have been trending lower now for around thirty-five years, broadly since the early 1980s.
Along the way the low in yields has been called over and over again, with economic forecasters falsely predicting large and sustained losses for bond investors.
A case in point was in 1994, when the US government bond market sold off very heavily. But many will argue that they moved far too soon, as in fact history has proved that there was some 20 years of a bond bull market still left to run.
A widespread and largely unexplained feature of investor behaviour during this current bond bull market has been that portfolios with long-dated liabilities have been managed short duration, for example, the income streams from the bond portfolio have been deliberately scheduled to run out earlier than the defined payment schedule known to be due.
This short-duration portfolio set up implied a number of gambles:
1. Investors believed they would be able to re-invest at higher rates in the future than the then current prevailing rates.
2. Investors believed they could generate total adequate returns – both absolute and risk adjusted – from other asset classes such as hedge funds, public and private equity and real estate to cover the liabilities.
3. Longevity increases were ignored, which compounded the problem because each year the liability duration did not move down as much as the asset portfolio duration.
As we now know, boring and complete asset liability matching was the low-cost option to avoid the punishingly high cost of (1) re-investing at what turned out to be much lower future bond yields than had been anticipated, (2) longevity costs and (3) the volatility of other asset classes.
Therefore investors who were short duration ended up with a compounding triple negative effect cocktail. This led to the panic buying of duration in 2016, exacerbated by quantitative easing, which drove more than €10 trillion (£8.5 trillion) of bonds to zero or negative yields.
In my view, we experienced the capitulation of investors in 2016 followed by a low in bond yields. Within a few months of the 2016 low in rates, bond yields have risen quite meaningfully.
Higher bond yields are only bad news for investors who have bought all, or the vast majority, of the bonds necessary for the rest of their lives and never need to buy another one.
The best way to beat inflation using bonds is do something similar to those investors who have lost out in the past 35 years: keep bond portfolio duration down below the long-term horizon and take some credit risk in bonds issued by businesses that will benefit from some increase in inflation and bond yields. Banks, insurance companies and specialist lenders, along with consumer goods and property companies, are good examples.
As inflation increases, investors will demand higher yields in compensation, and as shorter-dated bonds mature investors will have the option to re-invest at these higher future yields.
Remember that for an investor who is either approaching, or is in the at retirement phase of their lives, there is the need to balance income requirements, stability of capital value and security along with inflation protection.
To beat inflation, we recommend dividing capital into three portions based on the time horizon for use of the capital. So, using the horizon analogy, an astute bond investor could apply the following formula:
1. Horizon one: 0-5 yrs. Short-dated corporate bonds and high yield bonds (2.5 per cent net)
2. Horizon two: 5-10 yrs. Corporate hybrid capital, and asset-backed bonds (3.5 per cent net)
3. Horizon three: 10 years+ Corporate hybrid capital and subordinated financial debt (5 per cent net)
Take Horizon three as an example. This capital is not needed for 10 years and so can withstand some volatility as long as the bonds ultimately pay back and deliver the promised return. Here, an investor can buy five to seven-year hybrid capital and subordinated debt from the UK’s largest companies such as Aviva, Lloyds Bank and National Grid, where yields can be as high as 6 per cent.
Taking this precedent, 5 per cent net of fees beats current and medium-term inflation. In the event that there is a further increase in inflation and interest rates do go up then re-investment rates will be at even higher future yields.
Remember three key points to beat inflation using bonds:
1. The greater the duration (horizon) mismatch, the more risk will be taken on higher future rates.
2. Most investors still don’t get it – the biggest risk for bond investors is that future yields are lower, not higher.
3. With modest but sustained inflation and somewhat higher interest rates, the largest banks and insurance companies are good place to invest in lower ranked bonds. Don’t fight yesterday’s battles.
Peter Doherty is a fund manager of Tideway Investment Partners
Key points
A widespread and largely unexplained feature of investor behaviour during this current bond bull market has been that portfolios with long-dated liabilities have been managed “short duration”.
Boring and complete “asset liability matching” was the low cost option to avoid the punishingly high cost of re-investing.
The best way to beat inflation using bonds is do something similar to those investors who lost out in the past 35 years.
