Why bond yields are the most interesting they’ve been in a decade

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Now, let’s start with inflation. It’s usually a very difficult issue for bonds. So, how do bond investors cope with inflation at 9-10%? Can you cope with it or is it a losing battle?

[00:27] I think we’ve been answering that question for a solid year and a half now, since we saw the light at the end of the tunnel from the pandemic, and economies start to reopen. And we had unprecedented accommodative monetary policy that, in economic theory, is something that progresses inflation, coupled with a global economic shock with supply chain shocks. And then, coupled with the war in the Ukraine, which has obviously put a massive strain on energy supply around the world, which makes up a large basket of a lot of inflation measures. So, naturally there’s been a lot of unprecedented phenomena that have all come together at once. From a bond market perspective, it’s been very volatile. I think obviously markets are forward looking, and the difficult thing is that it’s very hard to try and price in very uncertain outlooks.

So, naturally, we’ve seen inflation expectations reach extreme highs, especially as the actual underlying prints have come through of, as you said, 9-10%, we’ve got 9.4% in the UK. But we’ve also seen these expectations come down recently, as we’ve had central banks start to begin their hiking cycles. We had the ECB hype 50 basis points. We had the Fed hike, 75 basis points. So, there is a glimmer of central banks trying to control this very unprecedented inflation.

From bond investors’ perspectives, naturally central bank outlooks need to retain optionality. I think, for us, it’s still very unclear what’s going to happen. Markets haven’t quite decided between the inflation and the growth narrative and which one’s going to take hold, whether we do get that recession. I think the stagflationary environment is almost inevitable. I think we’re already in a stagflationary environment. And the question is whether that’s going to push over into a full recession.

There are ways that bond investors can mitigate these risks. So, naturally, there are instruments in the bond markets that are directly linked to inflation. So, inflation linked bonds being the obvious one. We can, obviously, buy protection into our portfolios through these vehicles. We’ve also been keen over the last year or so on floating rate notes in both high yield and investment grade. These bonds have coupons that are linked to underlying reference rates, so they also provide a level of protection. But I think the key in this sort of environment, where inflation outlooks are so uncertain, is to be able to be dynamic and flexible. And the great thing about the funds that I work on is that we have all sorts of levers that we can pull in terms of both physical bonds, currency positioning, duration positioning, having direct inflation exposure through, as I’ve mentioned, those physical bonds and also through derivatives as well. So, I think it’s not a losing battle. Obviously, it makes things very difficult, but also interesting, but I think flexibility is key.

That’s interesting. Thank you. And perhaps we can talk a little bit about Europe now. One of the problems is the continent has multiple economies, but only one central bank – the ECB – which you said was just raised by 50 basis points. This can create issues at times like today, where there’s huge difference in yields between the Italian and German bonds – very close geographically, very different economies. Can you explain the issue and what the European central bank can do when they have one interest rate for all?

[04:05] Naturally, the concept of a unilateral monetary policy will obviously work for some and not for others. And I think that in this era of super high inflation and the ECB trying to rein that under control, there are very different economic responses from different areas. We also naturally have seen a lot of political turmoil in Italy, as you mentioned. So, no-one’s really quite sure what that future coalition or government will look like. Draghi has kind of gone back and forth on his intention to resign. So, Italy has, as well… I think there’s been 15 political shake ups in the last 18 years. So, they are due one every one and a half years, something like that. So, this one was actually a little bit late according to that time schedule, but naturally that political turmoil causes a lot of uncertainty in the bond markets and causes spreads to be very volatile.

The ECB has come out and said… there’s been a lot of talk about this anti fragmentation tool – so, that’s them trying to control that fragmentation between yields and between spreads. What we have is a new acronym to learn. We have the TPI, the new bond buying program that the ECB have announced that they will use to try and rein in Italian yields and spreads if they got to a level that they were uncomfortable with. I think the difficult part is that they have been particularly ambiguous in that we don’t know what size in which they would buy in. We don’t know what the levels are that they would be uncomfortable with. We had the emergency meeting when we got out to the 4% level of the 10 years.

That gives some indication of where the ECB starts to become a little uncomfortable, but they haven’t given a lot of precision in terms of what targets they’re going for. And they’ve also set out a number of both growth and fiscal conditions – macro kind of environments in which they would implement this bond buying program. So, there are four conditions that they’ve set out and these conditions are very, very subjective. It does provide some respite to markets in terms of that there is a kind of vehicle that can be used if need be. But I think the ambiguity and the subjectivity of it hasn’t reined in spreads in that much so far.

And while we’re on the subject of difficult political situations, we’ve yet more issues in the UK with a leadership contest for the new prime minister. The term ‘Trussenomics’ has been thrown around recently to describe some of the policies by front runner Liz Truss, that she might implement if she does win. What do you think this could mean for bond holders? What are the implications of her perspective policies?

[07:01] Naturally we’ve seen a lot of political turmoil in the UK of late, so we’re down to our final two. And, as you said, she’s the front runner within the kind of conservative grassroots members. There have been a lot of these kinds of headlines in the news at the moment in terms of Liz Truss and potential policies that she’s talking about implementing, both before she became one of the final two and after. I think Trussenomics is a term that’s been coined to describe, interestingly, what actually Conservancy party members have tried to implement for a while, and it’s essentially an environment of unfunded tax cuts that leads to very high growth and lower government borrowing. I don’t think we’ve actually ever properly seen this come to fruition, but that’s kind of the meaning of Trussenomics.

The thing that’s been grabbing headlines this week and recently has been her policy that she’s now U-turned on in terms of regional pay boards. I think people have found this a little contradictory with her potential policy of tax cuts. The idea of regional pay boards is to basically have, as the name describes, pay boards per region that decide the pay of public sector workers. And the point of it is to try and avoid the crowding out of private sector workers, especially in a very inflationary environment. What I think the mix up was is that the press has advocated that this has meant that existing public sector pay would be cut for your doctors and nurses and teachers. I think she has argued that it’s actually for future contracts, but in general she’s had a lot of pushback for it because people have felt that this would potentially lower pay going forward for public workers, potentially cause geographical disparities, that would be hard to incentivise people to leave London, for example, that would have higher pay because of higher costs of living, et cetera. There’s been a lot of pushback, and she’s now done a U-turn on this 5 billion policy saying that she’s now not going to push forward with it.

Another thing that has been in the news has been her approach to the Bank of England and monetary policy and potentially shaking up existing policies. For example, changing the inflation target, potentially combining it with the growth target, potentially combining it with the money supply target, and a variety of things like that. There have been some talk of potential institutional instability because of these potential shakeups, but there’s, again, lots of uncertainty. It feels like there’s still a lot to be seen in terms of the final policies from the two leaders.

Thank you. And now, finally, for the asset class as a whole, why should investors be considering bonds today? It’s obviously been a very difficult start of the year one of the hardest first halves of the year for decades, really. And are you hopeful for the second half of the year? Do you think this is the time for bonds to show why they deserve a place in the portfolio?

[10:14] I’m honestly not saying this because I’m biased as a bond fund manager, but I genuinely don’t think bond yields have been this interesting for a long time. We have investment grade corporate bonds yielding the same as equities at the moment, which obviously have a much lower level of risk in terms of the capital structure. Especially if the same company potentially for the equity and the bonds. We’re also seeing government bonds, especially short dated, looking at very attractive levels. And obviously this depends on investors’ outlooks on inflation and growth. And if you believe inflation has not yet been tamed and we have central banks coming out and saying that they’ll do whatever it takes in a very Draghi fashion or we had Fed speakers yesterday saying “we’re not close to almost done,” which provides a lot of question marks in terms of how aggressive the Fed are going to be going forward.

There’s a lot of question marks in terms of your outlook on inflation – if you don’t believe the hikes are done yet – then there are still opportunities in the long end of the curve. If you believe curves are going to retain a flattening bias. But also, if you believe that recession is around the corner, then naturally government bonds tend to do very well, as you have a flight to quality and you expect central banks to either slow the pace of hiking or actually come to cut rates. And we may well see that in certain environments.

The most ambiguous economy at the moment is naturally Europe, with geographical proximity to the war and having a lot more reliance on Russian oil and energy, et cetera. The outlook for bond markets there is more uncertain, but in many areas, for example, the US and the UK, it feels like bond yields may have peaked, it feels like they are looking very attractive. And even if the peak hasn’t come yet, I still think the entry point is very attractive going forward.

Emerging markets are looking interesting. I think credit markets look very interesting. Spreads are very wide because of a lot of illiquidity in the market, but based on fundamentals, you’re getting paid pretty well for the underlying credit risk. So, I really do think that bonds do look very interesting right now. Duration is definitely something to be starting to add back into portfolios at these levels. The thing with bond markets is they do move very, very fast. So, the risk of investors continuing to wait, you may miss the trade, but in genera,l markets are volatile. Perhaps the entry point is not quite yet, but I do think it will be in the next quarter or towards the end of the year because on an outright valuation basis, bond yields look very attractive in my opinion.