A combination of a likely economic recovery in 2021 and long-term societal changes mean Paul Brain, head of fixed income at Newton Investment Management, is preparing his portfolios for significantly higher inflation in the years ahead. But he is still buying government bonds, the asset class most likely to fall in price if inflation rises.
Thanks to central banks buying government bonds, and so pushing the prices up, US and UK government bonds are trading at or near, all time record high levels.
The income yield on a ten-year UK government bond is currently 0.22 per cent, while the US equivalent is 0.78 per cent.
The income from a bond is fixed, so if inflation rises sharply above those levels, the value of that income becomes less attractive.
Inflation in the UK is already above 0.22 per cent, with the figure for September being 0.5 per cent.
Mr Brain works on five bond funds at Newton, which is a subsidiary of BNY Mellon.
He says that while the world economy is presently performing at a level considerably below its long-term potential, and in recession, he believes the volume of support from governments and central banks will mean the “economic recovery will pick up speed next year", at the same time as interest rates remain low, and government spending remains high.
In those circumstances the likelihood is that inflation would rise, according to Mr Brain. He added the rise of populist politicians around the world meant that many of the trends associated with globalisation, such as the moving of manufacturing to lower cost locations, could reverse in the years ahead, while wages could rise as populist politicians seek to restrict immigration.
Mr Brain said in such a climate he was keen to avoid “the middle of the bond market” and instead buy high yield bonds, which do well when the economy is growing and also pay an income that is higher than inflation.
But he has also invested in government bonds, despite the high prices, low yields, and vulnerability to higher inflation.
He said: “Even though the yields are low, and you are potentially losing out on years of income, government bonds do offer protection.
"The bond buying programmes of governments aren’t going away, even if they are tapered back, and having a constant buyer in the market should help investors. And of course, in the event there is a worse economic downturn, the government bonds would likely rise in price and offer protection.”
Phil Milburn, fixed income income fund manager at Liontrust, owns some US government bonds, but not with any great enthusiasm. He said he owns the assets "because we always own sovereign bonds, and at the moment US government debt is the least worst option."
He is cautious about owning too many government bonds though. "While central banks are buying bonds now, and not really caring about the price they pay, it's easy for a bond fund manager to load up on those bonds and sell them on to the central bank later.
"But for that to make sense, central banks would have to keep buying bonds at this pace forever, and that's unlikely. At some point that will stop, and there will be a day of reckoning."
Luca Paolini, chief strategist at Pictet, is less optimistic about the outlook for the global economy, but is also keen to own government bonds.
He believes that even at the current price, US government bonds are a “reasonably priced” way to protect a portfolio right now.
Chris Iggo, chief investment officer at Axa Investment Managers, said one of the market conditions which might have made bond prices fall was if Joe Biden became US president, and had also won control of the Senate, and was therefore able to launch an extensive government spending programme, which would involve borrowing more money.
This would be done by issuing more bonds, increasing the supply, and potentially causing the price to fall. The extra spending might also have led to higher inflation, which is bad for bond prices.
Mr Biden is still on track to win the presidency, however his hopes of securing the Senate have faded.
But Mr Iggo said a Republican Senate should protect the price of US government bonds in the current climate, offering protection for investors.
Tom Sparke, investment director at GDIM, a discretionary fund management firm in Cambridge, said: “I think bonds still remain an essential building block of client portfolios for a number of reasons. Firstly, the protection of government or other highly-rated bonds is essential in markets which are still skittish and in a time when surprises and especially disappointments (eg with COVID-19 vaccine news) are coming regularly.
"Secondarily, the income that can be gleaned from fixed income brings a valuable stream of yield that is not beholden to the daily ups and downs in stock markets and this provides further diversification.
"When we assess the high yield sector, the total returns from these assets have been very generous of late and have contributed equity-like returns with significantly lower volatility.”
david.thorpe@ft.com
