‘The most bullish I’ve ever been in my career.’

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Hi, I’m Sam Slator from FundCalibre, and today I’ve been joined by Mike Riddell, who’s manager of the Allianz Strategic Bond fund. Hi Mike.

[00:10] Hi.

So, UK Bond markets have had a bit of an eventful couple of weeks. We’ve got our fourth chancellor now in 2022, I read just a moment ago. Could you perhaps try and explain just very briefly in layman’s terms what’s happened?

[00:30] Yes, I mean, it’s not just [been an eventful] couple of weeks, it’s actually been about a year. I mean, we’ve had the biggest bond sell-off that we’ve seen really since the 1980s, early 1980s. So, the biggest bond sell-off in 40 years. But in the UK this really reached a peak in the last couple of weeks – this volatility that we’ve seen and the size of the sell-off in the gilt market. I mean, just very briefly, and it’s difficult to explain briefly, but I’ll try!

You have a lot of pension funds, which have been forced sellers of gilts because they have some interest rate derivatives that they’ve been losing money on, and they therefore have to raise cash to pay the banks because they’re losing money on these derivatives. And, as they’ve been selling gilts, they’ve all been selling gilts together and the gilts have sold off, and that thing ends up with a doom loop where, because they sold-off, more guys have to sell and then it keeps going on and on and on.

A lot of this was brought about because of the mini budget, where mini wasn’t really the right word, I mean, it was earth shattering for the UK where we had a lot of fiscal stimulus announced and markets had been expecting this, but it was even bigger than expected. So, people are wondering who’s going to buy all these gilts? You know, if you do lots of borrowing and if you do fiscal stimulus, then you have to issue gilts. And at the same time as they’re trying to raise money to do fiscal stimulus, you’ve got the Bank of England that’s been trying to sell gilts – unwinding QE [quantitative easing] and also you have the UK economy going into recession, which means you’re going to have more borrowing anyway as well.

So, there was a bit of a heart attack in [the] markets. The Bank of England had to step in and temporarily calm things, and there’s a game of chicken between the Bank of England and the government. [The] government didn’t want to U-turn, at risk of looking even more silly. And then the Bank of England also didn’t want to be seen as funding the government’s borrowing plans, which weren’t really viewed as sensible. So, this has all come to a head.

The government appears to be the one that’s backed down. Hopefully this means that we’ll have less volatility in future, but we’ll see.

Yes, we’ve got one or two U-turns it looks like coming up in the next few days, and obviously the proper budget, if you can call it that, I think, in a couple of weeks’ time. So with that as a big caveat, because obviously we don’t know what will actually be announced then, what does it mean for bond investors going forward? Is it still bleak and gloomy, or are things actually looking better?

[02:47] Well, it’s important to differentiate what’s happened in the UK a little bit with what’s happened around the rest of the world. And of course, bond markets everywhere in the world have sold off. And this is because of the, well, really the high inflation numbers that we’ve seen, and actually economic growth was very strong last year. And that means there has to be more interest rate hikes.

Then we had a series of inflation shocks. First of all, gas prices going up, you know, quadrupling in the second half of last year. Then Russia/Ukraine just made this happen again. And this has created a lot of inflationary pressure. So it’s not just a UK story, it’s really a global government bond story, but the UK has been most exposed more recently because of the political problems.

In terms of what it means for bond investors going forward, I’d say that the best thing is that it means that valuations are now really attractive. I mean, if you’re buying – just focusing on the UK – a 30 year gilt you know, you’re getting, basically, an annual return if you hold that to maturity of 5%. So, a 5% yield means total return of 5% per year for 30 years. Now just in the middle of 2020, this was barely above zero. So, the potential returns that you now get in fixed income are actually really quite exciting. You have to believe that inflation is just going to be out of control, you know, and approaching really 5% for this to be a bad investment. And that’s definitely not our view.

If you look elsewhere in the world, you’re seeing a similar story with really attractive valuations, I’d say particularly in government bonds. I think when you start going down the credit risk spectrum and lending money to corporate bonds or even the riskier high yield corporate bonds where there is real risk of defaults on these things, I don’t think that the extra yield is really that attractive yet versus government bonds. I think the real value is in global government bonds right now.

Okay, thank you. And you’ve mentioned that sort of you’ve been talking about bonds all over the world. Obviously you can invest all over the world in your fund. Have you been making a lot of changes over the last year to take advantage of some of these big moves that are happening? Or what have you been doing in the fund?

[04:45] Yes, there’s been a lot of changes throughout the course of this year because the sell-off has just been unprecedented really in the last nine months, in global government bonds in particular, but really bond markets everywhere and that sell-off means that valuations have got much more attractive.

So, a year ago we were actually positioned really quite defensively. We thought bonds weren’t that attractive, we thought there weren’t enough interest rate hikes priced into the market. You know, growth was strong and inflation was clearly quite high. So we were actually very bearish about government bonds. But as we’ve seen the sell-off progress through this year, as those yields and, you know, return potential has got higher and higher, then we’ve been adding to what’s called duration, getting more bullish of interest rate duration. And what that means is, if at some point central banks need to cut rates or if the market even just thinks that they have to hike less than it’s currently thinking, you can start getting some really attractive capital gains now for the first time in a long time.

So we’ve been getting more bullish of government bonds, extending some of the maturities that we own, to really benefit from yields falling. In other words, the market thinking about rate cuts. You know, it sounds quite bleak, but we do believe there’s a serious risk of not just a deep recession – we’re already in a bit of a recession – but I mean even a deep recession and potential crises – not just crisis, but crises around the world.

And, while that’s not good news for most risky assets like equities or some of the lower rated corporate bonds, for government bonds this is really where they do the best. They are a safe haven. And when you get recession, that means less inflation, you’re creating spare capacity and government bonds can do extremely well in that environment. So, I am now the most bullish really, of government bonds I’ve ever been in my career right now. So, it might feel difficult and behave really difficult to do that when you’ve seen such a big sell-off, but I really think that the valuations are extremely attractive. I can’t actually get more bullish in my fund than I am
today.

And what kind of government bonds are you holding? Are any of those UK or are you looking for sort of US or maybe even Australian? 

[06:52] Yes, I mean the UK is where you have seen the valuations improve. Although we’ve been bullish of government bonds really everywhere in the developed world and even some of some emerging markets have been quite attractive.

We were a bit worried about the UK, because clearly there was political risk when it was apparent that Liz Truss and her team was going to be voted in. And they had said that, you know, we want to do fiscal stimulus and therefore I thought that gilts were a little bit vulnerable. You know, UK government bonds are all gilts, so we have generally avoided UK government bonds. We even had a slight short where we actually benefit a little bit as they sold off. Just this week, you know, when the yield’s really skyrocketing, we’ve got out of those. And we are getting much more bullish on UK government bonds too.

But I think the problem with really not just the UK, but any European bond market, is that these markets are vulnerable to another inflation shock. I mean, you can imagine a very grim scenario in Ukraine or the east of Europe, which results in, you know, yet more inflation shocks. You know, if we have a very cold winter this winter, which doesn’t seem likely given global warming, but it’s always possible, then we could end up with some serious energy problems and energy prices going crazy, even crazier than they already are. And that will mean more interest rate hikes and that’s bad for bonds.

So, the ones we’re really favouring are where we clearly see economic growth slowing, but where there’s not so much of a long term inflation problem. So, we are focusing on North America – Canada, US – some of Europe, like Scandinavia I think looks quite interesting, where a lot of it’s linked to the housing market. House prices are really starting to fall sharply. That suggests the economy is about to weaken, which is again good for those government bonds.

And you mentioned Australia, I think that’s another great example where you can get yields approaching 5% in Australian government bonds. Again, the housing market is under severe pressure. I expect they’ll be cutting interest rates, not hiking them in, you know, the middle of next year.

So, all things being equal, I think we’ve had the first two consecutive years of negative bond returns. [Is] 2023 going to be better?

[08:53] Yes, exactly. And I certainly hope so given how we’re positioned. You know, we are, as I say, positioned and the most bullishly we can possibly be and the most bullish I’ve ever been in my career, in terms of government bonds. I really think these are the most attractive valuations we’ve seen since the early 1980s. And we will benefit if economic growth starts to weaken, if – and it should do – if inflation starts to move lower.

And you have to remember about inflation: yes, the inflation rate is very high today, but a lot of this is because of the surge in commodity prices you saw over the last 12 months. And some of it is because of all these supply bottlenecks that we saw last year, you know, not enough, you know, ships to move things around the world or lockdowns in Chinese ports. A lot of these things have gone, you know, freight costs have collapsed. That’s very deflationary. The oil price is much lower than it was in April of this year. So, we assume that, you know, inflation, which is really a year-on-year change in prices, will start to move much lower in the first and second quarter of next year and back towards actually central bank target. If that happens, and if we’re in recession, then central banks can stop hiking rates, they can cut rates, and that’s just the most beautiful environment for government bonds.

That was really interesting. Thank you very much.

[10:05] Thanks very much.

And if you’d like to find out more about the Allianz Strategic Bond fund, please go to fundcalibre.com.