Four of the world’s cheapest markets
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In this interview Colin Finlayson, co-manager of Aegon Strategic Bond, gives us a thorough update to bond markets including why bonds have performed so badly including explanations as to why government bonds and inflation linked bonds have underperformed in this environment. Colin also tells us how the fund is positioning and a bit of hope for fixed income heading into 2023.
In this interview, James Yardley talks with Colin Finlayson, co-manager of Aegon Strategic Bond, who gives us an update to bond markets and explains why bonds – and in particular inflation-linked bonds – have performed so badly in this environment. Colin also tells us how the fund is positioned and gives us a bit of hope for fixed income heading into 2023.
Please Note: Below is a transcript of the video, modified for your reading pleasure. Please check the corresponding video before quoting in print, as it may contain small errors.
It’s been a disastrous start to the year for bonds. Can you tell our viewers what’s going on?
[00:19] You’re absolutely right. I think we’re in the midst of one of the worst six-month periods that fixed income markets have had in quite some time. There’s a couple of key factors here. The first one is the continued move away from ultra-low interest rates that we have seen for much of the last decade, and as we come out of the pandemic. Driving that has been much higher and more persistent levels of inflation that we’re seeing across all major markets. What that is doing is forcing central banks to aggressively raise interest rates at the same time that they’re removing a lot of their asset purchase schemes or QE programs. So, a lot of the backstop for fixed income markets that has been there for quite some years has come away at the same time. They’re having to deal with this higher inflation backdrop.
What that has meant is it has pushed government bond yields quite materially higher as they’re adjusting to this new, higher inflation, higher interest rate world. But at the same time, it’s also having quite a negative effect on corporate bond returns as well. So, in addition to the higher yield we’re seeing from the government bonds, we’re seeing credit spreads widen, again quite materially. They’re having to deal with this high inflation backdrop, as company earnings are being hit quite hard by rising input costs from the increase in the cost of labour. And also these new funding costs that they’re going to have to face when they’re having to undertake any future borrowing. All of that has meant that corporates are coming under more pressure and as a result, credit spreads have had to move wider to adjust for that.
And you put all of that together, what you’re left with is a very weak environment for fixed income returns, as they’re dealing with inflation on one side, central banks raising rates on the other, and that backstop from central banks not really being there. So, it’s really a bit of a perfect storm, but it’s been a long time coming given how low yields and spreads have been for quite some time.
Now your fund is a strategic bond fund. You have the mandate and the ability to be flexible. So, what sort of changes have you made to deal with this environment at the moment?
[02:44] Flexibility has been key in trying to navigate these markets. And the key thing for us is what it allows us to do is choose which risks we want to take, and which risks we want to avoid when we’re allocating within our portfolio. What we’ve been doing this year is we initially put a defensive setup in the fund. So, we wanted a low level of interest rate risk – or duration – and a lower level of credit risk in response to anticipated higher interest rates and higher government bond yields as a result.
What we’ve seen as the year’s progressed is the yields have in fact moved higher and credit spreads have moved wider. And we’ve been using that opportunity to moderate the kind of underweight position that we’ve had, adding interest rate risk back into the portfolio and adding additional credit risk as well.
But the flexibility of the fund allows us to tackle this problem in many different ways. So, we’ve had the ability to invest in some inflation-linked bonds at different times over the course of this year. We’re adjusting our preferences on yield curve positioning. So, we had a bias for holding longer dated bonds as opposed to shorter dated bonds for most of the last 12 months, although we’ve moderated that, and we’ve seen as short-dated bonds have performed quite poorly, that has been favourable for the fund.
And then also looking at the different parts of the fixed income market and where to invest. So, allocating a little bit more into the high yield market, which is less interest rate sensitive has been something that’s been beneficial and something that we’re able to do. And in choosing which markets to invest in, whether we want to invest in the UK or US, or in Europe or beyond, and using that flexibility to identify the best opportunities at that time also has been really about trying to mitigate as many of the risks that we’re facing through higher interest rates in this rising yield environment.
And I believe your primary focus is on government bonds, which are historically, at least supposed to be defensive when equity markets are falling. Obviously, that hasn’t been the case at the moment. So why is that?
[05:12] I think that’s really been because of the nature of the backdrop that we’re facing just now. In this higher inflation world that we are in, it impacts all financial assets together, whether that’s government bonds, corporate bonds, or equities because of the impact of funding costs and input costs means that they can impact equities as well as government bonds. The other thing we’ve seen is it’s not really sort of a risk-off type environment. We’re not seeing a flight to quality where, often the case when equities are falling due to some macro event, that tends to lead investors to want to de-risk and jump into government bonds. We haven’t necessarily seen that because the underlying growth picture up until now has actually been very strong. So, the willingness for investors to be jumping into government bonds has been much less. In a rising rate environment, government bonds tend to come under a lot of pressure. And therefore, the return outlook wouldn’t necessarily be particularly constructive.
So, I think it’s just the nature of the backdrop that we are in, where the price of risk was too expensive. All financial assets had got to the point where they were overvalued. And they’re now having to adjust to this new world that we are in. And in many ways, it’s about trying to work out what the new clearing prices are, whether it’s bonds or equities in this new, higher interest rate world. And right now, we’re still trying to find where that floor is. Until that is the case, you’re likely to still see bouts of weakness across all financial assets. So, it’s a peculiarity of the environment that we are in, that it means that you can see equities falling and government bonds falling in value. That won’t persist forever. And there will be a point where that traditional correlation will re-exert itself.
And what’s been particularly interesting is yes, government bonds have done badly, but actually inflation-linked bonds or inflation-linked government bonds have done even worse which is sort of counterintuitive given that we’ve had higher inflation, you’d have thought that would be the place where you could perhaps hide at the moment, but it certainly hasn’t been the case. So, can you just explain to our viewers what’s going on there?
[07:48] Yes. Inflation-linked bonds… The name can be slightly misleading in terms of giving you confidence that these are the perfect assets to own when you’ve got higher levels of inflation and that’s not necessarily the case. Inflation-linked bonds, like all bonds, have interest rate risk within them. So, what you’ll find is that as yields move higher, the value of these assets will decline in the same way that investments in gilts or investment grade corporate bonds would also fall as well. And because the index-linked market as a whole has a higher interest rate risk sensitivity than you’d find in other government bond markets, then they will tend to be at risk of losing more capital when yields are rising.
But if you take an inflation-link bond of a similar maturity, what you will find is that in a period of rising inflation expectations, they should do relatively better than an equivalent conventional government bond, because the value of them is influenced by the level of inflation.
But the other problem with inflation-linked bonds, is they are quite forward looking and they react more to inflation expectations than actual realised inflation. So, once you reach a point where the market perceives that we’re nearing a peak in inflation, or that central banks are getting serious about dealing with that inflation problem, that’s generally the time you want to be moving away from inflation-linked bonds, and into conventional government bonds.
One thing you can do, if you are concerned about rising inflation and using inflation-linked bonds, is you can try and remove some of the interest rate sensitivity within that. And then you can benefit from the relative performance compared to conventional gilts which is something we do within our portfolio. But as a standalone investment, it is very dangerous to invest in an inflation-linked bond, even when inflation is high, if you’re expecting yields to move higher at the same time, because they do have duration sensitivity. So, I think investors should be really mindful of that before they start loading up on inflation-linked bonds.
I believe for the central banks to get ahead of inflation, they want real rates to rise. And real rates going up of course is bad for the index-linked bonds. But that’s very well explained. Thank you, Colin.
That’s been a little bit depressing, but that is all behind us now. We’ve suffered a lot of pain, so looking forward can we be a bit more positive now in the second half of this year and looking to 2023, are we going to see perhaps a peak in inflation and bonds doing a bit better?
[10:50] I think we are approaching a period where the outlook is much more constructive. The two key elements here are, as you mentioned, the peak in inflation, which we expect to come in the second half of the year, and alongside that interest rate expectations, or how much the central banks are going to hike rates. A lot of that is very well known and a lot of that is now priced into the valuations of bonds. At the same time, corporate bonds spreads have moved to very wide levels and are implying a much higher level of defaults than we think is going to be realised. So, from a valuation standpoint, this has become a very attractive time to be adding additional fixed income risk into your portfolios.
For a medium and long-term investor I think these are very compelling levels to be adding risk. In the short term there’s going to continue to be volatility. We are seeing risks still coming from Eastern Europe and what’s happening over there. Concerns about what is happening with the flow of gas into Europe and what that can mean. So, there is going to be short term volatility that’s going to impact values over the course of the next few months. But when you look beyond that and into next year, if you’ve been able to add risk today, I think is very compelling, particularly on the corporate bond side. All in, yields and the level of additional spread that you’re being paid, is more than compensating you for the risk we’re facing. We think it is likely that we’re going to enter some form of recession – probably into next year. But I think bond markets are already factoring a lot of that into their prices. So, for us, we do think this would be a good time to be looking to add additional fixed income risk into your portfolios.