November 2022
Global bond markets have performed horribly in 2022 as inflation has soared. The UK Government bond (gilt) market was also torpedoed by a disastrous UK mini budget at the end of September which saw the FTSE Actuaries UK Conventional Gilt Index plunge by 10% in the course of just two days. These losses have since been recovered following the replacement of the fiscally reckless Truss/Kwarteng combination with the fiscally conservative pairing of Sunak and Hunt.
Bonds are generally held in portfolios to diversify and complement exposure to equity markets. They also provide a steady income stream. Historically, this complementary relationship has proved invaluable when an economy goes into recession as investors typically dump riskier assets, such as equities, and seek the safety of bonds in a flight to quality. However, high inflation is the nemesis of conventional bonds in which the payments of interest and the repayment of capital when a bond matures are fixed because it erodes the value in real terms of both. As a consequence, bonds have provided no protection in 2022 as stock markets have tumbled.
So, have bonds had their day and is their traditional role as providing a buffer to equity exposure broken? First, not all bonds are the same. Interest and capital repayments from some are linked to inflation, some pay interest at floating rates, some have ultra-short durations, some bring exposure to other currencies and creditworthiness, and hence risks and yields, can vary widely. The universe of bonds is very diverse. For this reason, we employ strategic bond managers, who can be nimble in their portfolio construction and take advantage of opportunities where and when they occur in the broad spectrum of bond markets.
Despite their shocking performance so far this year, we believe that bonds still have an important role in portfolios. Indeed, the case for bonds is now actually more compelling because of their recent poor performance and the yields that are now on offer. This does not mean that yields cannot go higher from this point, as economic risks clearly do still exist, but at these levels at least, the bond markets are beginning to look interesting. The case for bonds in portfolios is detailed below:
- As fears about inflation give way to fears of recession and its damaging impact on corporate profits, there is no reason to believe that investors will still not seek out the traditional safe harbour of high-quality bonds.
- At the beginning of the year, 10-year gilt yields stood at 1%. The scope for them to fall (and prices therefore to rise) was therefore limited. 10-year gilts now yield close to 3.5% so the scope for profit is now much increased.
- Although inflation in the UK is likely to remain close to 10% for the next few months, it is expected to fall significantly thereafter. The market expectations of inflation over 5-year and 10-year time periods are both currently at around 3.5%, meaning 10-year gilts are now close to offering a real (after inflation) return for the first time in many, many years.
- The £ Corporate Bond market now also offers much more attractive yields. This is not only because gilt yields have increased but also because credit spreads (the extra interest paid by companies compared to governments) have widened from about 1% to 2.5% since the beginning of the year (as measured by the ICE BoA Sterling Corporate Bond Index). The average yield of high quality £ Corporate Bonds at the beginning of the year was 2%. It is now just under 6% and such a return is not to be sniffed at.
- The same trends have given rise to similar opportunities outside the UK too. The intrinsically higher yielding part of the bond market (think emerging market debt and lower quality corporate debt) is a diverse and disparate universe, but it has not been spared in the great bond market sell off. The US High Yield Bond market as a whole currently yields close to 9%. Great care is clearly needed when considering investments in emerging market debt, especially if that debt is a liability in US dollars. However, attractive opportunities abound in local currency debt markets for those managers with the skillsets to navigate them.
