David Roberts

Is there value in bond markets?

David Roberts

The recent market sell-off has been driven by investor nervousness over inflation. But the spectre of inflation is nothing new, so why has this happened now? The answer is central bank action. With central bankers finally – if tentatively – admitting that price rises could warrant some sort of action, yields have risen sharply. Indeed, the Bank of America UK Gilt index fell around 3.8% in September to stand down by more than 7.6% for 2021. So much for a risk-free store of value!

Central bankers in the US and Europe have now explicitly acknowledged mild concern that prices for some goods and services had risen a bit and could remain elevated. Pictures of panicked petrol purchasers at UK fuel pumps and of ships waiting to dock in California suggested more than mild concern was required. The most recent G7-wide CPI (Consumer Price Index) data for the 12 months to the end of August showed inflation rising at 4%. Most commentators, ourselves included, would suggest this number under-reports actual consumer price rises and conclude that – in the short term at least – CPI could move even higher.

We have said repeatedly that the past decade of free money has created an economic imbalance and asset price bubbles. The Bank of England, US Federal Reserve and European Central Bank now seem to agree, with monetary accommodation set to be reduced.

Government bonds sold off sharply as investors realised the “buyer of last resort” may not be around as much. With yields on government bonds likely to keep rising as policy is tightened, the key question for bond investors now appears to be: “where can we find value in bond markets?”

To believe there is value in bond markets currently you’d need to agree with one of the following statements:

  • Bond prices will rise (or the risk of capital loss is small).

    Can this really be true? Despite their recent rise, bond yields are still near record lows. The yield on 10-year UK government bonds recently moved up to a 1% yield. If they went back down to 0.5% then you’d gain around 4% (the duration of the bonds is around 8 years). But for that to happen, central banks would need to cut rates and increase quantitative easing (QE) – the opposite of the direction that policy is now headed.

  • A small positive nominal return is acceptable.

    To believe this, you’d have to ignore the effects of inflation. Let’s stick with our example of 10-year government bonds which now yield 1%. If we believe the Bank of England’s forecasts are accurate, UK CPI is set to average 3% until 2023. This means real returns on these 10-year bonds are -2%. We don’t think anyone should find value in this!

  • Bonds should be owned – regardless of yield levels – due to their ability to diversify portfolio risk.

    This logic has some appeal, but for the last decade bonds haven’t offered the portfolio diversification benefits that you’d expect. Bonds and equities have drifted up in price together. Of course, with QE reducing and bond yields rising, many commentators are now saying equities are also vulnerable as all the free money comes out of our system.

  • Bonds need to be owned for regulatory or contractual reasons.

    Portfolio managers who run income or balanced mandates may feel they have little choice but to chase bond coupons despite the miserly overall yields to maturity that these investments offer. Life and pension funds certainly have little choice but to own them.

  • Alpha can be targeted over beta.

    This is where things start to make sense for us. We own bonds in our funds, but we do so primarily in pursuit of market alpha opportunities: such as curve positioning, market-neutral cross-market trades and box trades. We have low exposure to market beta as we think it’s unlikely that bond markets can drift much higher again.

  • The bond market shouldn’t be viewed as a single entity.

Again, we agree with this point. As an investor, you need to recognise the difference between sovereign, investment grade and high yield bonds to uncover value. Sovereign bonds react badly to good economic news whereas investment grade can be mixed and high yield does well. Under most conditions, one or other part of the bond market can do well – unless of course higher bond yields push all risk assets lower. But if you are worried about that, you probably don’t want to own equities either.

In our bond funds, we have the flexibility to target the alpha opportunities as described in the last two bullet points which allows us to own bonds for the right reasons. At present, we are light on market beta, running with low duration levels as we expect the bond market sell-off to continue. We are not happy with sub-CPI nominal yield levels (i.e., negative real yields) so we will not own government bonds in a buy-and-hold strategy. We will attempt to extract alpha within specific markets: currently we are long US, New Zealand and Sweden, where rate hikes are priced in, but we are short Canada, Australia and Germany where they are not.

Inflation continues to rise and central banks appear to have run out of patience. But, so far, only the government bond market seems to have noticed. If yields do continue to rise, the equity market and other segments of the bond market will swiftly seem vulnerable to the repricing of risk.

We stand ready to tactically add more beta if the sell-off worsens. In the meantime, we find plenty of alpha trades that allow us to target positive returns without over-exposing our funds to deeply unattractive beta risk.

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Key Risks

Past performance is not a guide to future performance. The value of an investment and the income generated from it can fall as well as rise and is not guaranteed. You may get back less than you originally invested. Past performance is not a guide to future performance. The value of an investment and the income generated from it can fall as well as rise and is not guaranteed. You may get back less than you originally invested. The issue of units/shares in Liontrust Funds may be subject to an initial charge, which will have an impact on the realisable value of the investment, particularly in the short term. Investments should always be considered as long term.

Investment in Funds managed by the Global Fixed Income team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The value of fixed income securities will fall if the issuer is unable to repay its debt or has its credit rating reduced. Generally, the higher the perceived credit risk of the issuer, the higher the rate of interest. Bond markets may be subject to reduced liquidity. The Funds may invest in emerging markets/soft currencies and in financial derivative instruments, both of which may have the effect of increasing volatility.

Disclaimer

This blog should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Examples of stocks are provided for general information only to demonstrate our investment philosophy.  It contains information and analysis that is believed to be accurate at the time of publication, but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Liontrust as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. It should not be copied, forwarded, reproduced, divulged or otherwise distributed in any form whether by way of fax, email, oral or otherwise, in whole or in part without the express and prior written consent of Liontrust. Always research your own investments and if you are not a professional investor please consult a regulated financial adviser regarding the suitability of such an investment for you and your personal circumstances. 
Tuesday, October 12, 2021, 12:43 PM