Fear of inflation is a good reason for not investing all your portfolio in low-yielding bond funds, but not for investing nothing in such funds. For investors with low to medium risk tolerance an allocation to government bonds makes sense as a diversifier for equity holdings.
It is true that a gilt fund is of little use to an investor looking for an income. One per cent yield is unlikely to satisfy all but the richest investors, and that income is likely to be worth less each year as inflation bites.
However, for those with a total return perspective the data shows clearly that gilts have continued to do a good job for investors in UK equities by rallying when their shares have fallen. Yields are indeed lower than they have been in recent years, but this does not mean that they cannot go even lower and bonds cannot make money in certain scenarios. At the time of writing the 10-year Bund is yielding just under 0.3 per cent and the 10-year Japanese Government Bond 0.05 per cent.
Last summer the Bund yield fell below zero per cent.
Gilts could make real gains from here in a truly bearish scenario for the UK economy. Were a 10-year bond yielding 1 per cent to see its yield fall to zero per cent, investors would see nominal price gains of 8 per cent or 9 per cent, meaning that they would have positive returns in real terms in all but the most extreme inflationary environment. Were yields to fall to 0.5 per cent, where they were last year after the Brexit vote, investors would make around half that.
A lot of the anxiety around yields at current levels comes from the fear that there is a bubble in bonds. Since the 1980s there has been a secular drift down in yields and that when this comes to an end, people will start selling bonds and keep selling as they would do with equities during a crash. Typically, quantitative easing is blamed for accelerating the final falls in yields and as being somehow “artificial”, and therefore likely to cause a sharp reversal when investors wake up to their mistake.
However, there is no reason that yields should revert to the high levels we saw in the late 1970s and early 1980s. Bond yields are determined by growth and inflation expectations which are in turn determined by economic fundamentals such as demographics, technology and productivity: the return from bonds should compensate you for the nominal growth in the economy expected over the term of your investment plus a component for the risk of lending to a given issuer and for a given period.
In the short term, the depreciation of sterling is leading to inflation in the UK, but this is a one-off event working its way through the numbers. The prospects for inflation over the medium term are much lower than they were 40 years ago. Indeed, one of the reasons that the 10-year gilt yield fell even as CPI figures came in above target is that investors are looking through the current spike to the prospects for inflation over the next 10 years, and over that time frame the fundamentals are likely to reassert themselves. If you think we are likely to see a huge sell-off in gilts, you need to explain what would push UK growth and inflation so high.
In the 1970s, increased fiscal spending for the Vietnam War in the US, plus demographic pressures and the birth of the OPEC oil cartel resulted in inflation and a corresponding spike in bond yields.
Economic fundamentals now push in a different direction over the medium term: the world’s demographics are currently deflationary (China’s working age population peaked last year), while cheap shale gas and environmentally-friendly alternatives mean OPEC’s power is significantly diminished. In developed markets such as the UK and the US the trend rate of growth has significantly slowed, which is at least in part connected to demographics.
It is also worth reflecting on how calmly the market has absorbed the recent explanation by the Federal Reserve of how they will slowly reduce their balance sheet. Treasury yields actually fell after the bank raised rates during the same meeting. It hardly seems likely that when the selling of Treasuries commences it will be the signal for a sell-off if advanced warning is treated so nonchalantly, yet this is the final inflection point the catastrophists can point to as a potential spark for mass selling of safe haven bonds.
It is true that the immediate inflation outlook for the UK is different from that in the US due to the depreciation of sterling following our vote to leave the EU. The fact that yields are not reacting to increasing inflation figures tells you in part that investors are more concerned about what a slowdown in retail spending means for the UK stock market – the market fears the UK business cycle has been distorted by the Brexit vote and our economy has decoupled from that of the US.
If the economy turns and the stock market falls then the limited losses due to inflation may see attractive compared to the potentially more substantial losses from equities, particularly if the investor is likely to need the capital back sooner.
Essentially investors have to invest in assets which are likely to lose money in different circumstances and ensure they are not invested in lots of things that will lose money at the same time. If they want to jettison gilts because they are concerned about the risk of inflation then they need to explain what other asset offers the protection when equities fall without that potential for losses at other times.
The alternative that fund managers have been selling is absolute return funds. The sector includes a variety of strategies with different return profiles, but the only such strategies which would be likely to consistently give positive returns in falling equity markets would be funds which are structurally shorting equities, which would necessitate the fund making losses when equities rise.
That is, unless you are looking for an absolute return manager who can consistently shift his or her portfolio long and short equities depending on what is about to happen, which requires a belief in the ability of a fund manager to consistently foresee the future.
Targeted Absolute Return funds are often sold as a solution to the rising correlation between equities and bonds, targeting investors concerned that bonds will not protect in falling markets as they have in the past. However, looking over a longer period current correlations are actually comparatively low.
There have been short term spikes in correlation between gilts and equities, but these have only lasted a few days or weeks and have generally been around the time of changing expectations for the path of future interest rates or QE programmes, that is, just before or after meetings of the Federal Reserve board. However, if you look over more substantial time frames the correlation benefit from adding gilts to equities has remained substantial.
Looking on a one-year rolling period since the financial crisis, for example, we can see positive periods were short-lived and the figure reached above 0.3 only momentarily, with the figure turning negative again on each occasion. A correlation below 0.3 on a one-year basis is still very low.
In fact, it is important that the period during this time that correlations were the highest (much of 2013 and 2014) was the period of a bull market for equities: a benign spike in correlations; in other words, during which both asset classes were generally making money. When the FTSE All Share corrected in the second half of 2015 the correlation fell and turned negative again, as gilts protected while equities fell.
This is in line with historical trends. Since the 1980s there have been periods of much higher correlations between the two asset classes. However, these have generally been when equity markets are rising. When equities subsequently fell off a cliff – as with The Wall Street Crash in 1987 and the Dotcom crash in 2000 – correlations dramatically reduced and Gilts made money as equities were selling off.
Most diversified investors would welcome losses on their bond portfolio if it meant that their equity funds were rising, as this is where the long term growth of their portfolio is going to come from. So should we see any sustained pick-up in inflation due to economic strength then the diversified investor will do well. Retaining a position in gilts is insurance against a scenario for the economy that makes losing 3 per cent on an investment thanks to inflation attractive compared to the losses expected in equities.
Thomas McMahon is a senior fund analyst of FE
Key points
A gilt fund is of little use to an investor looking for an income.
The depreciation of sterling is leading to inflation in the UK.
There have been short term spikes in correlation between gilts and equities.
