The lessons to draw from the bond market blitz

Many investors will use bonds as ballast for their portfolio. During their lifetime, these tradable debt securities will provide regular income in the form of coupons, paid in a set amount at a pre-determined time – that Is why bonds are known as “fixed income,” after all. Unless the issuer of the debt gets into financial trouble the original investment, or principal, will also be repaid when the bonds mature. Equally, portfolio-builders may own bond funds for similar reasons.

A period of low, unchanged interest rates and very subdued inflation also mean it is tempting to simply buy bonds and forget about them. But if this situation changes then fixed-income could suddenly become a much more volatile arena, where prices can rise and fall quite sharply. In the latter instance it is even possible the price declines represent losses which more than offset the income from the coupons. If an investor can withstand these price movements and is not a forced seller then this matters not, as they can simply hold the bond(s) to maturity.

Yet this could be a concern for anyone who is in drawdown, for example, or does need cash for any reason and is a seller of fixed income holdings out of choice or necessity. Bond funds, whether they are actively or passively run, could also offer capital losses as well as gains, with the passive option such as exchange-traded funds (ETFs) actually designed to follow fixed-income indices lower or higher. Equally, experienced bond fund managers might see any price swings in bonds as an opportunity and chance to get access to coupon payment streams at price levels that are so attractive there is a chance to make some capital gains too.

May’s outbreak of bond market turmoil makes all of these questions pertinent and investors have several options:

• They can simply sit tight in the view deflation remains the biggest threat and as such bonds and bond funds remain a worthy consideration for any balanced portfolio.
• They can take evasive action and sell their bonds or bond funds, in the view inflation and interest rate rises are coming, a scenario which could make the yields available on Government bonds in particular relatively unattractive.
• They can target short-duration bonds, with relative little time to maturity. These bonds offer lower coupons but are less sensitive to the threat posed by interest rate rises. The price of long-dated bonds and high-yield paper will swing around a lot more as market perceptions of the trajectory of interest rates continue to change.
• They can maintain bond exposure by targeting areas which offer higher coupons, in the view any inflationary creep and interest rate hikes will be slow and steady. Investment grade corporate debt, sub-investment grade corporate debt (high yield, or junk) and emerging market sovereign debt are potential angles here. A further alternative would be inflation-linked bonds.
• They can cover as many bases as possible and buy a range of bonds – or entrust cash to a flexible or unconstrained bond fund. Such vehicles will buy bonds across a range of maturities, types and geographies. A skilled fund manager will protect capital and generate healthy income if they get it right, but if they find themselves in the wrong duration, geography or asset class (government, coporate or junk) they can suffer losses too. A good number of these bond funds can be found in the GBP Cautious Allocation category.

Best performing GBP Cautious Allocation bond funds over the last five years

Source: Morningstar, for GBP Cautious Allocation category

Mayhem in May

Just like a share, the yield on a bond rises when its price falls and the yield falls when the price rises.

This first chart shows the yield on the UK, US and German 10-year Government bonds, known as Gilts, Treasuries and Bunds respectively.

Source: Thomson Reuters Datastream

Yields have just shot higher so prices have been going down. The second chart shows by just how much:

Source: Thomson Reuters Datastream

The UK 10-year has fallen by 5% in price and its US and German equivalents by 4% and 5% respectively. Such falls wipe out moe than two years of coupons in one fell swoop if any British or American investors had to sell now for any reason, having bought at the top, while a Geman holder is sitting on a loss worth a few decades of coupons had they bought in late April.

These movements are even more dramatic in the 30-year paper.

Source: Thomson Reuters Datastream

Source: Thomson Reuters Datastream

Yields have spiked higher and prices plunged. Anyone who bought at the top would lose 10% on UK 30-year paper, 13% on the US and17% on the German paper if they sold now. This is no laughing matter when the yields they accepted were 2.05%, 2.25% and 0.44% respectively.

Sudden snapback

The oddest thing is that there appears to be no one particular catalyst for the sudden reversal in bond prices. Bond yields normally rise for one of three reasons:

• Investors are frightened that the borrower – or issuer of the debt – may not be able to pay the coupons and return the principal on time
• The market decides interest rates are about to go up, something which may make the coupons available on existing bonds less appetising, so investors start to sell their current bond holdings to make way for paper with a higher coupon
• The market decides inflation is about to go up, something which also may make the coupons available on existing bonds less appetising, at least in real, inflation-adjusted terms. Investors may start to sell their current bond holdings to make way for paper with a higher coupon

At the moment:

• It seems unlikely anyone thinks the UK, US or Germany is close to default
• The European Central Bank is running a Quantitative Easing programme until September 2016 and is thus still easing monetary policy, not tightening it. The Bank of England may only raise headline interest rates next year and the US Federal Reserve is hardly rushing to hike borrowing costs either.
• Inflation remains subdued and is running at way less than the 2% annual run rate targeted by the Bank of England, European Central Bank and the US Federal Reserve (as well as the Bank of Japan, for that matter).

That looks to rule out all of the usual suspects but of the three the inflationary explanation seems the most likely for now. Oil and copper prices have rallied, after all.

Source: Thomson Reuters Datastream

Moreover, interest rates cuts in China, QE in Sweden and central bank moves to lower borrowing costs in more than 20 countries this year, plus some improved economic momentum in Europe, at least offer some grounds for thinking inflation may be on the way. After all the major central banks are targeting 2% inflation and seem determined to get it. If they succeed then current Government bond yields barely compensate holders for that risk in the UK and US and leave investors facing real-terms losses in Japan and Europe.

Price was not right

The fourth possible explanation is simply that bonds had become overbought. The yield on German 10-year Bunds had sunk to 0.05%, trillions of euros worth of European debt had begun to offer a negative yield with even Poland getting in on the act. At the very end of April Warsaw managed to issue CHF 80 million in Swiss Franc-denominated bonds with a yield to maturity of -0.213%. That pretty much called the top (at least for now).

It only really makes sense to buy a bond that offers you a guaranteed loss, albeit a small one, if you think everything else is about to go to hell in a handcart. For the moment, the bond market volatility has not impacted stock markets even if May’s market action has inflicted a lot of pain on those who were buying Government bonds at the start of the month. Whether investors have substantial exposure to bond or bond funds or not, they must all watch the fixed income arena with care.

If the yield on 10-year Gilts ever rises back above the 3.25% or so currently available from the FTSE All-Share then some investors may start to prefer the calmer waters of fixed income to the rough and tumble of equities, even if such an eventuality may seem unlikely now, with a 10-year Gilt yield of 1.90%.

The final pair of charts shows how the 10-year Gilt yield compares to that of the FTSE All-Share and then how the yield differential between the two correlates with the equity index’s performance.

Source: Thomson Reuters Datastream

Source: Thomson Reuters Datastream

Since 2010 at least, the greater the premium yield offered by equities over Gilts, the higher the FTSE All-Share has gone so it will be interesting to see what might happen when and if that premium begins to disappear.

Russ Mould
AJ Bell Investment Director