How to survive the bond market blitz

While equities, commodities and the dollar are all responding favourably to the prospect of a Trump Presidency, and its tax-cutting, regulation-reducing and infrastructure-spending agenda, one asset class is proving much less enthusiastic.

That is fixed income, as bond yields have risen and prices fallen, amid expectations that GDP growth is going to accelerate and drag inflation along for the ride. This is helped by the possibility of a firmer oil price, in the event OPEC can reach a definitive agreement on production cuts (and then stick to it) at the meeting scheduled for 30 November in Vienna.

A comparison between the two tables below, which show yields on sovereign bonds in seven key markets three months ago and those of today, provides some quantification of the degree of the bond market blitz.

Global sovereign bond yields have risen sharply since early autumn...

Source: Thomson Reuters Datastream, as of 7 September 2016

... and the trend has accelerated sharply since Trump’s election

Source: Thomson Reuters Datastream, as of 22 November 2016

These sharp movements mean investors who bought near the bond yield bottom/price top in late summer and early autumn are now sat on (paper) losses, which substantially outweigh the benefits of many years worth of coupons or interest payments on those tradeable loans.

The same problem faces holders of bond funds, particularly those which focus on just one segment of the market – government bonds, corporate bonds or sub-investment grade ‘junk’ bonds.

This issue is actually more acute for holders of bond funds than those who own individual bonds. A single bond has a maturity date and (barring default and disaster) the initial loan will be repaid at a pre-set level (usually the issue price), so anyone who buys at issue and holds to redemption will have every chance of emerging unscathed. A bond fund – active or passive – has no maturity date and will run for ever, as it will own a mix of paper with different maturity profiles. As such, such collectives are not without risk, even if bonds are generally portrayed as instruments that are relatively safe, certainly compared to equities where the danger of capital loss is higher.

This is not to say bondholders should panic (as panicking is never a good investment strategy).

• Bond fund managers will look to manage their portfolio’s duration – the percentage change in price relative to a one per cent change in interest rates or bond yields – to strike a suitable balance between the yield generated and the risk to capital represented by possible price changes
• It is possible to buy so-called flexible or strategic bond funds, which do not target just UK Government bonds of a certain maturity profile, but put capital to work across a range of countries, maturities, issuers (Government, corporate or supra-national) and even type (index-linked, convertible, mortgage-backed and others).

There is also the chance that the market could be wrong and that hopes for the reflation trade inspired by a rebounding oil price and talk of fiscal stimulus and infrastructure spending in the US and UK (to name but two) prove premature. As such, caution on bonds is clearly required after a 30-year bull run and given some of the skinny sovereign yields on say European Government debt, but fixed-income may still have a role to play in a balanced portfolio, especially for those investors who are seeking reliable income and are able to withstand near-term capital volatility.

Pain trade

That said,the fixed income asset class has inflicted a lot of pain on holders of bond funds, whether they are actively or passively managed. Inflation expectations have marched higher.

US inflation expectations have surged

Source: FRED, St. Louis Federal Reserve database

As a result, bond prices have fallen sharply. The three examples below help to quantify the degree of discomfort.

First, the price indices for the US 10-year Treasury bond and UK 10-year Gilt have fallen by 7.6% and 6.9% from their highs. That might not sound like a lot but it is enough to wipe out five years’ worth of coupons on the US paper and all of the interest payments due over the entire life of the British issue.

UK and US 10-year Government bonds have fallen sharply in price

Source: Thomson Reuters Datastream

Second, holders of bond Exchange-Traded Funds (ETFs), or stock market quoted trackerswhich follow a basket of bonds, have also seen a sharp reversal of fortune. This chart shows the iShares Global Government Bond and iShares Core UK Gilts Bond ETFs. They have fallen in price by 6.7% and 8.5% from their respective peaks.

Government bond tracker funds have been caught up in the melee...

Source: Thomson Reuters Datastream

Finally, this graphic looks at the UK-quoted iShares Core Sterling Corporate Bond tracker and then the US-listed junk-bond tracker, the iShares iBoxx $ High Yield Corporate Bond ETF. Intriguingly, the junk bond tracker has fallen by less than 2% from its high while the investment grade one has taken a near-9% tumble.

.... as have corporate bond trackers

Source: Thomson Reuters Datastream

Been here before

Unpleasant as this has been, it does not mean any bond exposure is undesirable. Some fixed income presence in portfolios may still suit investors, depending on their overall investment goals, target returns, time horizon and appetite for risk, especially as the current enthusiasm for growth and inflation-based trades could simply prove misplaced.

As noted in last week’s column:

• We have been here before. Japan has tried a combination of weak currency, zero rates, QE and fiscal stimulus over the past 27 years to no great avail, in the face of the same deflationary demographic and debt forces which now burden the West. The Nikkei index still stands at less than half its 1989 high (despite half a dozen very substantial rallies) and Japanese Government Bonds have become known as ‘the widow-makers’ for their ability to confound bears and see their yields go lower once more as the initial effects of any stimulus have worn off.

Japanese Government bonds have confounded the bears for over 25 years

Source: Thomson Reuters Datastream

• The highly-respected strategist David Rosenberg of Gluskin Sheff reminds us that President Obama launched an $860 billion ‘shovel-ready’ infrastructure programme in 2009, the effects of which upon US economic growth were transitory at best. In addition, Rosenberg notes that Eisenhower spent more on roads than any modern US President, yet in the 1950s America suffered a pair of recessions (as defined by two consecutive quarters of economic decline), despite this infrastructure splurge.

In addition, President Trump, Prime Minister May and others face specific challenges of their own.

• Neither Government is flush with cash, unlike America was under Eisenhower in the 1950s or Reagan in the 1980s, when infrastructure spending and tax cuts were widely seen as good for the economy. New British Chancellor of the Exchequer Philip Hammond describes this nation’s debts as “eye-watering” and the 85% debt-to-GDP number attests to that, since the aggregate Government debt is £1.6 trillion – this year’s overspend of some £60 billion is adding to an already massive debt burden.

The US total deficit is so much higher now than it was in the 1950s or 1980s

Source: Thomson Reuters Datastream

A ballooning UK debt figure also constrains potential spending plans

Source: Office for National Statistics

• It takes time for infrastructure projects to bear fruit. The UK’s Heathrow farrago is a classic case in point, as the lead-time here is huge and the project still faces local opposition even if national Government is supporting the scheme.

It is also worth bearing in mind that many have tried to call the top of the bond bull run before and many have failed. The Japanese example above is an extreme one, but just look at the two charts below for US 10-year Treasuries and UK 10-year Gilts – yields have surged (and therefore prices fallen) on a good dozen occasions since 1983 in the case of the former and 10 times since 1986 at the latter, only to subsequently regain the lost ground and more each time.

US 10-year Treasuries have already seen 12 sell-offs since 1983

Source: Thomson Reuters Datastream

... and the UK 10-year Gilt has retreated sharply 10 times since 1986 (only to forge fresh advances on occasion)

Source: Thomson Reuters Datastream

There remains the distinct possibility that the latest sell-off is just the latest head-fake. Powerful deflationary forces, such as debt, demographics and the price-crushing internet are still very much at work.

Also note that there is a danger to the bulls that the inflation trade proves self-defeating, owing to the scale of the globe’s debts, at government, corporate and consumer level. The spike in US Government bonds means US 30-year mortgage rates have rebounded to the 4% mark, something which could put a brake on housing demand and consumer spending, for example.

Any US Federal Reserve rate hikes in response to rising inflation could drive the dollar higher and a bouncy buck is traditionally seen as deflationary (or at least disinflationary) – it makes dollar-priced commodities more expensive and also drains liquidity away by making it more expensive for nations who borrow in so-called Eurodollars (any country who takes out a US-dollar price loan that is not America) to service their debts. That is why emerging market assets in particular have historically done poorly when the greenback is strong.

Flexible approach

If interest rates (or inflation) do rocket that it will be easy to look back and with hindsight argue that bonds at this stage of a 35-year bull run offered nothing more than return-free risk.

Yet the US Federal Reserve is still taking only the tiniest steps to raise interest rates and the Bank of England is showing no inclination at all to hike headline borrowing costs in the UK. That may exert some gravitational pull on Government bond yields.

Few investors may want to directly buy an individual bond, government or corporate, so they may prefer to go with a fund, even if the open maturity of these collectives does present a challenge.

The diversification would be a useful protection against any sudden shift in Fed or Bank of England Policy or the market’s inflation expectations and a further rise in bond yields.

The table below lists the five best performing flexible global bond funds over the last five years.

Best performing flexible bonds funds over the last five years

Source: Trustnet, Morningstar, for GBP Strategic Bond category
Where more than one class of fund features only the best performer is listed.

It may be then worth analysing these collectives for their asset allocations by asset class (Government, investment grade or high yield), geographic mix and where possible maturity profile, in the knowledge the shorter the duration of a fund’s holdings the better protected it is against interest rate rises, and the longer the duration the better performance will be if bond yields come back down and interest rates do not go up as quickly as some now expect.

Russ Mould, AJ Bell Investment Director