Tapping into the bond attraction
This article first appeared on Octomembers.com on 17th November 2022 “How do you prepare for the...
Bonds are usually boring.
Without drama or fanfare, they pay a steady stream of income over a period of time and, all things being equal, you get your money back at the end.
This week, they have been anything but. To the point that, last night, wine glass in hand, I found myself enthusiastically explaining to a friend why UK government bond yields going over 5% is such a momentous event (sorry Pernille, I realise I probably won’t be invited back).
It’s actually been a bad year for bonds – not just a bad week. Interest rates in the world’s developed market economies had been in a zero-bound range for the best part of five years. In some cases, they had even been negative and bond holders were paying governments for the privilege of lending them money. Crazy stuff.
But rapidly rising inflation in recent months has resulted in interest rates also rising – faster and higher than many anticipated. This, in turn, has increased bond yields, meaning the price of bonds have fallen and bond holders have lost money.
As Jim Leaviss, manager of M&G Global Macro Bond pointed out last week, a five-year US investment grade bond yields almost 5% today – it was yielding just 1% last year.
But while there are obvious worries in the short term, in the long-term higher yields could be a good thing for investors. AXA Investment Management’s Chris Iggo explains: “Bond returns are negative because interest rates have gone up from levels that we all knew could never be sustained,” he said. “If you go through an extraordinary period in markets – defined by unparalleled central bank interventions – then it is ridiculous to expect an immediate return to normality. The last year has been about re-setting the risk-free rate, the overnight interest rate. That process is clearly not over yet.
“Because we now have higher yields, the hypothetical return profile has changed. If a bond yields 1% [as they did last year] and has a duration of 7-years, a 1% rise in yields will deliver a total return (over a year) of -6%. It’s very unlikely that yields would fall by 1% [in that instance], but if they did, the total return would be 8%. But at low yields – where we were in 2020 for example – the risk is more skewed to yields going up.
“By contrast, a bond with a yield of 3.5% would see a total return of -3.5% should yields go up by 1% and a total return of 10.5% should yields fall by 1%. It’s clear that with higher yields, the risk-return profile is superior.
“To me, that strengthens the case for multi-asset investing – having bonds alongside equities today, gives more diversification than it did two or three years ago.
“We’ve gone from TINA to TIAA – There Is No Alternative [to equities], to There Is An Alternative,” he said. Investment grade and high yield bonds are now looking attractive.
“While it’s still hard to get excited about longer-dated bonds as there is no ‘term premium’ at the moment – you’re not getting paid more for lending longer – short-duration investment grade and high yield bonds are now looking attractive.”
Jonathan Platt, manager of Royal London Corporate Bond fund, also agrees there are opportunities emerging.
“In my opinion, UK government bonds are cheap,” he said. “With markets pricing a 6% bank rate by May next year, the economy faces some severe headwinds. Yes, the energy price cap will help, and tax cuts will boost spending power, but the impact of higher interest and mortgage rates will negate these benefits. I don’t see lower corporation taxes doing anything in the short term to boost investment.
“Second, credit is cheaper still. Yes, we are heading for a recession and interest costs will rise but this is more than discounted in valuations. The last time I saw such value was over 10 years ago. I appreciate that there is a lot of bad news out there: Russian belligerence, gas price hikes, the prospect of falling house prices, a significant budget and current account deficits in the UK. But that is the time to stay calm, evaluate probabilities and invest for the medium term.”