198. Why even inflation-linked bonds are letting you down

23 June 2022 (pre-recorded 16 June 2022)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION] 

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. This week we’re focusing on the global bond market. With high inflation and interest rates rising around the globe, not to mention the prospect of recession, it been tough for bonds. But could there be opportunities soon? In this very education podcast, Dickie Hodges, manager of Nomura Global Dynamic Bond, explains exactly what is happening.

Darius McDermott (DM): I’m Darius McDermott from FundCalibre and this is the Investing on the go podcast. Today, this morning, we had the fifth consecutive interest rate rise from the Bank of England, and they are signalling inflation of 11% in October. So, who better to be joined by than our pal Richard “Dickie” Hodges, manager of the Nomura Global Dynamic Bond fund. 

[INTERVIEW]

DM: Dickie, a lot going on out there, it’s been a choppy day, choppy week, choppy year in markets – both bond and equities. Normally, if we get recessions, the stock market comes first it tells you that it’s coming. There’s this wobble. Where does the bond market tip for that? Is that something that leads the equity market? What does the bond market tell us today? Broad question.

Richard “Dickie” Hodges (RH): Thank you for inviting me, Darius, first of all. 

So, if we look to see what the bond market, where it’s come from is the important part. We now see long term 30-year bond yields north of 2.5%. We’ve got a 16% negative return year to date on not only the UK bond market, we’ve got index linked gilts – the inflation immunised products – that have returned minus 22% year to date. So, one’s got to ask – the question is – why are these returns so negative? And it’s all as you suggested down to the level of inflation: what is the appropriate level of Bank of England official rates for the level of inflation to contain that growing inflation? As you suggested.

DM: Yeah.

RH: Today, it is 9% plus. It is forecast to go closer to 11%, yet we only have short term interest rates in the UK at 1-1.25%.

DM: Yeah. 

RH: So, you’ve got to say from that perspective inflation is not rolling over sufficiently quick enough. We still have all the problems and the reasons why inflation is at these levels to begin with. That’s the supply chain issues, the Russia conflict with Ukraine, the fact that China and other broad Asian [countries] are still in lockdown. So, the fact is that we are going to, for the foreseeable future, see elevated levels of inflation. Under those terms, short term interest rates have to go higher and therefore one would suggest that long term bond yields will also have to go higher. 

The fact of the matter is we are closer to the point of a recession, and we’re not just talking about a recession in the UK. 

DM: No, that’s right. 

RH: We’re talking about a recession in the US and most definitely within Europe. 

DM: Yeah. And in Japan.

RH: Indeed. We’ve still got further to go, unfortunately.

DM: So, there’s a couple of interesting points there. So, for the layman, I understand bonds are down, right? Inflation is up, rates are going up, bonds go down. It’s a fairly inverse relationship. Why are inflation linked bonds down? Given inflation is so high. To our listeners, you know, I don’t understand that, I would’ve thought ‘linkers’ had to be up?

RH: Well very much this is the issue. Index linked gilts are a financial debt obligation that is linked to the level of inflation. Unfortunately, index linked gilts also have what is known as a very long duration, longer dated bonds, a longer duration, means they have more sensitivity to changes in bond yields. So, if bond yields go higher, the longer the maturity means the greater fall in cash prices. So even though these index link gilts have benefited from a higher measure of inflation, the fact is that long term bond yields have gone higher. These are longer dated assets. So, the fall in price is considerably higher, which is again why I said we’ve seen minus 22% out of inflation immunised index link gilts, and only minus 16% out of conventional bonds.

DM: And it is the fact that traditional index linked gilts have longer maturity, longer duration, and therefore have been more sensitive and underperformed greater for that reason.

RH: Absolutely it’s due to do with the structure of the pension fund industry. We’re trying to, the government was issuing longer dated assets to meet the liability… 

DM: Future liabilities. 

RH: …That have been growing in maturity, as well as demographics and health. And we live longer. So therefore those sort of securities are much longer in maturity, much more sensitive to changes in interest rates. And if interest rates go up, then unfortunately, as we’ve seen this year, the price of these assets goes down.

DM: So, as at today, we’ve had five consecutive months where interest rates have gone up in the UK. The Fed, which is the US equivalent of the Bank of England were behind the UK and raising, but then went and slapped a full 0.75% on the table for US rate rises. Are we nearer the end? Or how do you see the rest of 2022 playing out with respect to rate rises and then into bonds and what we might expect from bond returns because anything that’s down 16%, is it a buying time, is now the time to bang the desk?

RH: Yeah, I think arguably, for obvious reasons, we’re closer because interest rates have already moved to go higher. We therefore must be closer to what is referred to as the terminal rate of interest rates. You mentioned about the US and putting up interest rates by 0.75%. 

DM: Yeah. 

RH: This is the largest interest rate rise that we’ve seen for a considerable time out of the US. The probability is that we will see another 0.75%, Chairman Powell, the governor of the FOMC, which is the Federal Open Market Committee, the governor of the US bank, told us that we shouldn’t expect 0.75% hiking rates to be normal. But the next rate hike, we should expect between 0.50% and 0.75%. At the same time, the terminal rate that the market expects – this is where interest rates end up, where we’ll end up – has gone higher. So we are now expecting the terminal rate on US interest rates to move from something like 2.5% closer to 3.25%. So, arguably we’ve got more rate rises coming. 

We have a higher measure of inflation, which is prompting this activity. The Federal Reserve is coming from what we refer to in the industry as being behind the curve – meaning too slow – not addressing the inflation issue to moving rapidly up to the curve, which is putting up interest rates at an appropriate measure to try and stem the rise in inflation. 

How will they do this? Well, the higher the level of interest rates go, the higher the level of mortgage rates go. Mortgage rates in the US now are at the highest level they’ve been since 1987. They’re currently just short of 6%. So the cost of servicing debt, mortgages, has increased significantly. At the same time, US consumers are borrowing more money on credit card and commercial loans than at any single point in history. And, as a consequence of this, the saving rate in the US is at the lowest rate it has ever been. 

So, if you were to actually have a look at a chart, imagine borrowing has got a near vertical line going upwards and savings is a near vertical line going downwards. That can only lead to one thing. And that is, you’ll see a drawdown in consumption. Costs go up, less disposable income. The Fed still has to address this issue. And the way they’ll do this is to actually push the US economy into a recession. It is the only way that they can realistically address the issue of the escalation and inflation and arguably the same should, we infer, is the same issue will be for the UK.

DM: So ,what’s that terminal rate then in the UK? Or is that something that’s not… 

RH: Well, this is the biggest debate that we’re having. The fact of the matter is one of the only asset that has gone up in value this year, as we know, equity markets have got negative returns. Global, in fact, the UK is better positioned with less negative returns than anywhere else in the world. The only asset that’s gone up and has a double-digit positive return year to date is that of the UK housing market. We’re all facing greater utility bills, less disposable income. 

DM: Yeah.

RH: The fact of the matter is, if we’ve borrowed, you’ve seen home equity withdrawal, you know, this is a factor globally, money being taken out against property valuations. We feel more comfortable because the value of our house has gone up 10%. What happens if the value of the house goes down 10%? Not only have we got increased bills, you know, we would also face less disposable income, less confidence.

DM: Well the consumer spends less.

RH: This is very true. At the moment, the one thing which we can see is probably a good thing from the UK economy traditionally would be viewed is as we see on the news, there are more jobs than there are people to fill those vacancies. That unfortunately is not sufficient enough to stop the UK economy from slowing. So, all of these reasons are understood by the Bank of England. And so the fact of the matter is they’re reticent to move interest rates as aggressively higher as we’ve seen elsewhere, not just the US, but emerging economies and even the Swiss National Bank surprised with a 0.50% today. A complete surprise out of the blue. They raised interest rates by 0.50% today. This took capital markets, both equity and debt capital markets, by complete surprise and resulted in significant falls today. 

DM: Yeah. So, we’ve touched quite a lot then on the UK and US, which have had two rate rises in the last 24 hours. Can we make money anywhere on the globe? What are we doing now? I know you are a truly global as in the name of the fund, but you actually are truly global and I want to touch on Russia right at the end, but it doesn’t look good for Europe either, does it? Where do we go to make it? 

RH: Europe is a given that it’s going into a recession. And in fact, the more recent news from the European Central Bank is concerned over what they refer to as fragmentation. What is fragmentation? If you think German government bonds, which are the equivalent of UK gilts. And then you think of other European economies. So, the developed, the core European economies, Netherlands, Germany, France, these sort of Northern European. And then you’ve got the peripheral economies, Spain, Italy, Greece. Borrowing costs in Italy and Greece have doubled – easily doubled. It was only a year ago that 30-year interest rates borrowing for Italy over 30 years…

DM: That’s Italian government bonds

RH: Yes, Italian government bonds. A year ago, it was 2%. Today it is above 4%. So, you’ve got German government debt significantly lower. That means in yield. That means that it’s easier for Germany to finance their borrowing requirements. It’s significantly difficult for Italy. And that in itself will put strains on the Italian economy, strains on the single currency. So, the European central bank…

DM: It’s starting to sound like 2011, 2013 again [European Sovereign Debt Crisis].

RH: This is the issue. This is recognised by the European Central Bank. So, they’re trying to come to a solution. But the fact of the matter is Europe is absolutely facing a recession. It’ll be, it’ll become, it’ll be evident. It’s already evident from the numbers that we see, a sharp contraction will come in the final quarter of this year. So, the fact of the matter is we are going into a technical recession in Germany, and Germany is the stalwart of the European economy.

If we’re having a recession in Germany, well, where else is Europe going to go? So, the fact of the matter is that we’re facing issues across all capital markets. How do you generate returns in an environment that we know as, we now understand as stagflation – this is a falling economy, negative economic growth, with rising inflation. 

The problem with this is it’s very difficult to value an asset or an asset class if you don’t know how high interest rates are going to go. 

DM: Yeah. 

RH: How do you know, how can you discount? One of the measures of valuing a cash flow of a company is the discount rate. If you don’t know what that discount rate’s going to be, how can you value the company today? If you can’t value their cash flow, how can you value their equity? And if you can’t value the equity, how can you value the equity market? So, this is the issue that’s facing us. We are going into a recession. This is going to put strains on it, but you’ve got to think from another side of this. 

This is the best opportunity that we have seen for quite some time to generate returns in 2023 and 2024 out of fixed income asset classes. One would argue that equity market will still be showing some signs of stress because we are going into a recession. The key on everything is when we are told by central banks that they have finished raising interest rates. At that point, we all know what the terminal rate is. We will have confidence that interest rates aren’t going to go up any further. We can value an asset. And from that moment on and let’s face it assets are significantly cheaper.

DM: Significantly cheaper than today, I mean, I look at some global growth funds and they’re already down 50%. 

RH: Well, this is true, but there’s no, it might not be that they’re cheaper than today, but there’s no reason why they should go up tomorrow. 

DM: Yeah. 

RH: You need a reason for things to start – confidence in investor’s confidence and behaviour. The problem is with investment, from a behaviour perspective, if an asset halves in value, it looks significantly more attractive for obvious reasons from the investment perspective. So ,we tend to invest bits of money, part of our investment. What we’ve experienced though, these assets have dropped in value. We’ve invested, they’ve dropped in value again. We’ve invested. The more that asset classes fall in value, the less comfortable we are with investing again in the future. And at some point, this is where we reach this level. 

DM: Maximum level of pain I suppose. 

RH: This is very true. Having a known level of Bank of England base rates allows us to then draw a line to value assets. And if indeed asset classes have moved down 16%, 20%, under that reason, you’ve got a better probability that you are going to deliver those sort of positive returns in subsequent future years.

DM: So how, and I know you said it’s very difficult in stagflationary times. What have you done in the Global Dynamic Bond fund that you run at the moment? I want to touch on valuations right at the end because I know there’s a segue to Russia. 

RH: Yeah. 

DM: But how are you positioned? I mean, I don’t want every line, but what at that headline rate can you do?

RH:  I mean, yeah, well, first and foremost, it’s very difficult for any fund. One of the obligations of funds is not only to deliver a total return. What is the total return? It’s the return out of capital and income. Absolutely. The only way that you would’ve returned anything other than a negative return is if you had a hundred percent cash this year and you were paying no distribution. 

DM: Yep. 

RH: That is the only way that we would’ve seen anything delivering a positive return. I looked across all asset classes within fixed income and every single fixed income asset class with the exception of Chinese government bonds, has delivered a negative return this year. So first and foremost, it has been exceptionally difficult to pay a distribution and not to have negative returns. We can see this against all types of fixed income funds, whether it be a UK government fund, which is perceived to be safe because it’s AA rated, to UK corporate funds and to high yield funds, all of them double digit negative returns. We ourselves have suffered double digit negative returns. We’ll discuss in the final point. 

DM: Yep. 

RH: One of the positives for the future. But the fact of the matter is it’s been exceptionally difficult to immunise against changes in interest rates and inflation. And why is this? Because everything is correlated. Typically, when equity markets fall, government bond markets go up, give you a positive return. Unfortunately, everything’s correlated, because the cost of financing leverage has gone up, ie interest rates have gone up. Everything is correlated. You’ve seen equity markets fall, you’ve seen bond market prices fall at the same time. It’s very unusual. And the driver of this is the elevated levels of inflation. The likes we haven’t seen in 30 odd years. And the fact is, the uncertainty on how much further interest rates will go. 

All of those will become apparent as we move forward to the end of this year. So, I think there is some opportunity, but the real opportunity to deliver these sort of double digit returns out of things like UK government debt, UK corporate debt, more governments, is in 2023. But the fact of the matter is we are still going to be facing issues of increased volatility, higher interest rates, and persistent inflation. Inflation will roll over without a shadow of doubt by the end of this year, inflation will be lower than where it is today and where it’s projected to go tomorrow. But by the end of the year, the realisation that we are moving into recession, the interest rates are not going to go as high as people are concerned, will mean that you should see government bond yields moving lower and, with lower bond yields, you get higher prices and a positive return.

DM: That’s absolutely fantastic. So maybe a fraction more pain and then loads of gain in 2023?

RH: Pretty much that’s the summary of it all. 

DM: So look, I’ve known you a long time. I’ve known you are a truly global investor. I know in the last number of years you’ve made money out of Egypt and peripheral Europe where you’ve just found extraordinarily good value for the risk of owning such assets. But we did have a little bit in Russia early in the year. Just tell us briefly how that impacted on the fund, and what the potential for recovery is on those assets.

RH: Yeah. Well, first and foremost, we don’t condone what Russia’s been doing with Ukraine. We find this as horrific as everybody else does. We’ve been invested in Russia for the last three years for all the reasons why: Russia is oil. Russia is gas. Russia is gold. Russia’s government. domestic debt was something like 25% of GDP. It was a fraction of the debt outstanding in the majority of other global countries. So, the fact is there was every reason why you would want to invest in Russia. Default probability was extremely low because they’re basically oil and gold. So, the fact of the matter is, there was every reason and we’ve generated some good returns out of having exposure to Russian sovereign government, local currency debt. 

The fact of the matter is, like everybody else, we found it highly surprising that Russia actually, first and foremost recognised the separatist regions of Donbas and Luhansk, which was a prelude to the invasion of Ukraine. As a result of that, the central bank of Russia imposed restrictions on international accounts from transacting anything in their domestic sovereign debt, and also stopped the receipt of coupons that were due, dividends, the coupons that were due on that debt. Those coupons are being paid, but they’re being paid into a domestic Russian account. So, they haven’t disappeared. We just don’t have access to it.

DM: Do you expect you will?

RH: Absolutely. Also, the fact is the debt within the fund, we’ve marked because it’s no value. You can’t trade it. It’s worthless. We marked it down to zero. At some stage, once the central bank of Russia removes those restrictions, this debt will have…

DM: Will have some value.

RH: Will have a lot of value. At which point we will look to exit our exposure to them. But the amount of value that they have is fairly considerable. Bond prices have gone up domestically. Russia are cutting interest rates. You cut interest, and Russia last month, negative inflation print, the only place in the world where there’s a negative inflation print.

DM: Dickie on that note, I think that’s been an excellent roundup. So much happening in equities, but particularly with rates and bonds. So ,thank you very much for taking the time to talk to us today. 

If you’d like more in information on the Nomura Global Dynamic Bond fund, please do visit fundcalibre.com and please do subscribe to the Investing on the go podcast. 

But from me, in summary, it has been a tough year for fixed income. With rates very much telegraphed to rise, the second half will be challenging as well. But when those rates rise, actually there are decent yields on bonds, could well be the surprise asset class for 2023.

SW: The Nomura Global Dynamic is an unconstrained strategic bond fund, with a focus on total returns. Dickie invests in the entire range of bond sectors including government bonds, corporate bonds, emerging market bonds and inflation-linked bonds. To learn more about the Nomura Global Dynamic Bond fund, visit fundcalibre.com – and don’t forget to subscribe to the Investing on the go podcast, available wherever you get your podcasts.

Please remember, we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at the time of listening. Elite Ratings are based on FundCalibre’s research methodology and are the opinion of FundCalibre’s research team only.