Why bond yields are rising, and why it matters
Bonds have not had a good start to 2021. The average UK Gilt fund is down 7% and every other bond...
In a world of ultra-low interest rates, most property owners understand the importance of mortgage ‘stress testing’. It’s easy to imagine how difficult life could become if rates rose even just one or two per cent, especially given the value of the average home loan. Strangely, we don’t seem as concerned about the impact of rising rates on our bond investments.
In the last week of July, multi-national telecoms conglomerate, AT&T, launched the third largest bond sale on record, looking to raise just over US$22 billion to help fund its acquisition of Time Warner. The yields AT&T offered were extraordinarily low for corporate bonds, yet the issue was three times oversubscribed.
AT&T has not been the only US conglomerate to get a good deal on its long-term borrowing this year. Amazon just raised US$16 billion, with a yield only 1.45% above US treasury 40-year bonds. And Tesla raised US$1.8 billion (its initial ask was US$1.5 billion) in its first ever bond issue, at a record low yield for a bond of its maturity and rating, Bloomberg said.
Because all this talk of rates and issues and maturities can be confusing, let me summarise it simply: cheap funding for these companies equals expensive bonds for investors. Are we so desperate for yield we’re accepting too little in return for the risks?
In the UK, the major buyer of corporate bonds between September last year and April this year was the Bank of England, which reintroduced its quantitative easing program in the wake of the Brexit vote to keep money flowing through the economy. The bank bought £10 billion in corporate bonds over this period*.
However, according to Richard Woolnough, manager of Elite Rated M&G Optimal Income, M&G Corporate Bond and M&G Strategic Corporate Bond, the immediate Brexit risks are somewhat stabilised and emergency measures are no longer required. Richard believes the bank will, in fact, soon look to start selling some of its corporate bonds. Can it do that without flooding the market and driving down valuations? It will be a delicate balance.
The European Central Bank will eventually face the same dilemma. It has given no indication it wants to sell yet, but its corporate bond buying has been extensive and with European economies finally looking better than they have in years, the exit of these holdings must begin at some point.
Not only this, but since the start of 2017, economists have been talking about a ‘turning point’ in the economic cycle. A few interest rate hikes from the US Federal Reserve, as well as a stronger global growth outlook and rising inflation in several economies (notably in the eurozone), are slowly altering the message from central banks around the world.
Even taking a more positive view and extrapolating that a healthy global economy should support decent profit growth and good corporate credit metrics doesn’t negate the risks that a faster-than-anticipated pick-up in rates or inflation could rapidly erode the value of your bonds.
The tricky thing about the bond market, however, is that it continues to defy the odds. We, along with many fund managers of the asset class, urge caution when investing in fixed interest right now. We believe that the 30+ year bull run is coming to an end; the question is simply when.
Getting the timing right matters, because being too defensive while others continue to buy will not necessarily pay off either in the short term. High yield bonds have outperformed investment grade this year and longer duration sectors have outperformed the short end^. Both of these factors suggest sentiment around bonds remains positive and investors are not worried about companies defaulting if rates rise.
Ultimately, there are only a handful of managers I trust to handle the crucial mix of long-term strategic buys and shorter-term tactical. Take a look at our Elite Rated corporate and strategic bond funds to see some of those whom I consider to be the best in the business.
*Is it time for Bank of England to sell corporate bonds back to the market? M&G blog, Richard Woolnough
^Iggo’s Insight, Chris Iggo, CIO Fixed Income, AXA Investment Managers, 18 Aug 2017. Based on the performance of Bank of America/Merrill Lynch bond indices