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David Roberts
David Roberts 12-04-21

Bond markets during a global pandemic

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise.

Global stock markets ended 2020 close to record highs, with the UK being one notable exception. To some, this suggests a disconnect between everyday lives during a global pandemic and the behaviour of stock markets and investors. While volatile, however, stock markets have continued to break records so far during 2021, with the US’ S&P500 Index passing through the 4,000 level for the first time on 1 April.

What of bond markets? How have they performed over the past year of Covid-19 given the increase in quantitative easing (QE) to encourage spending and investment mostly through buying government bonds alongside historically low interest rates?

Bond markets have not escaped the volatility endured by all asset classes, with the dire global pandemic, together with associated fiscal and monetary responses, determining patterns of return for most of the year.

As 2019 ended, most investors had reasons to be cheerful. Global growth looked nicely balanced and inflation had risen gently to central bank targets. Even monetary policy seemed set to be “normalised” gradually, at a pace designed not to upset risk assets. Bond yields, which had fallen on geopolitical and deflationary fears in 2019, started to push higher in the fourth quarter – so anyone buying US 10-year government bonds in late December was paid around 2% per annum.

The first quarter of 2020 started in benign fashion, with the two events expected to dominate the year being the UK’s final Brexit deal and Donald Trump’s procession to a second Presidential term. Few people had heard of Wuhan.

News of the virus started to create some uncertainty by mid-February of 2020 and cases being reported in Europe meant this could no longer be considered “just” an Asian problem. Government debt performed well in the early weeks of the year, but a select few investors chose correctly to start to hedge against a bigger problem.

Stock markets and corporate bonds rallied regardless, indeed in part because sovereign yields were falling. For a decade, risk markets have been wrapped in central banks’ “low yields are great” comfort blanket, and why should 2020 be any different?

A year later, of course, we can say the comfort blanket was, if anything, wrapped even more tightly. And owners of risk assets ultimately had little to fear – other than panicked or forced selling before the political and central banks’ cavalry rode over the hill.

March was wild, making the aftermath of the Lehman crisis feel like the proverbial Teddy Bears’ Picnic. I know, I was there for both. And having also experienced Black Monday, 9/11 and, for those who remember, the collapse of Long Term Capital Management (LTCM), we knew what to expect, which was that at some point central banks would have no choice but to intervene. This happened in mid-March.

Before then, the Global Bond index had fallen more than 5%, which was scary given half of this comprises G7 sovereign debt, for which daily returns are normally measured in single digit basis points. As an example, the chart below shows the performance of AAA-rated New Zealand sovereign bonds (remember the country had very few Covid cases) and US Government Inflation Linked Bonds, more of which later.

Normally in times of stress we expect high-quality, government-supported assets to rise in value. Therefore, the sell-off, never mind the magnitude of the sell-off, was deeply concerning. Bonds that are expected to provide diversification and protection were falling, albeit not quite as spectacularly as stock markets.

As I mentioned earlier, experience taught us that a response would be forthcoming. However, I doubt many expected the response to be so swift and so substantial. Certainly, few would have predicted the near $20 trillion of fiscal response from global governments from March 2020, especially after a decade of self-imposed financial austerity.

Authorities reacted to what was clearly a nascent, imminent demand collapse. Perhaps their response was triggered by the oil market? Remember that brief period when, in theory at least, producers paid people to take oil from them?

I am often scathing and seldom supportive of monetary and fiscal authorities. From 2009 to 2020, zero and negative rate policy, together with open market bond purchases (QE to you and me), manipulated bond prices and provided cover for politicians to abdicate responsibility and fail to deliver positive economic policy. Japan and Europe may have been at the bottom of the class, but the remainder of the G7 failed to win any gold stars.

I believe history will show that the creation of “free capital” in a non-crisis period destroyed efficiency and potential economic growth in favour of cheap shot financial asset rallies. The rich get richer, the poor poorer and social division increases.

It would be easy to find fault with some of the responses we saw to the Covid-19 crisis during 2020. However, in the face of a global pandemic and after a decade of “minding the pennies”, I believe we have to thank Jerome Powell (Chair of the Federal Reserve) and Christine Lagarde (President of the European Central Bank), as well as myriad G7 politicians, for getting most of the support mechanisms right and, vitally, getting it done quickly. Who would have believed the Federal Reserve would buy ETFs? Europe remains the laggard, but this is an embedded structural issue for which perhaps lessons from the pandemic can act as a catalyst for change.

And this response had the desired impact. Confidence quickly returned, not so much for the economic outlook of course. Comfort was given that there would be a “backstop bid”, a floor under asset prices irrespective of the economic environment, which was almost a “bad news is good news” argument: the worse things get, the more the central banks are there for us.

Not all assets performed equally well. Some sectors – travel and leisure, bricks and mortar retail in particular – were hard hit, although government support packages prevented a wave of bankruptcies. This was essential. The lesson from 2009 was that the banking sector, for all its faults, needed to be saved. If not, whither the oil to the capitalist machine? Stop the banks writing down capital, writing off bad debt and they can be used to flood the market with support.

And how did this play out in bond markets? Well, the rebound was swift and (almost) all-encompassing. Core government bonds quickly recovered from their March panic as investors were desperate for anything close to a safe haven. But prices of most other bonds, from investment grade (the likes of Apple and Barclays) through high yield (think Netflix) to emerging markets, rapidly recovered. And more.

By the end of 2020, sovereign bonds had fallen a little from their highs, with close to $20 trillion of debt at one point traded with a negative yield. You had to pay to lend to the German government for anything from one day to 30 years; strange times indeed.

The light at the end of the tunnel became brighter thanks to an incredible effort across the globe aimed at finding vaccine solutions. As the year drew to a close, most investors breathed a sigh of relief; 2020 was for many assets ultimately a year of stellar returns with the 5.0% provided by the Global Bond market (the return from the Barclays Global Aggregate Hedge GBP Index) well above anything most had predicted 12 months earlier.

This situation would prove to be short lived, however. Many wondered what the impact of all the emergency responses, both fiscal and monetary, would be and would 2021 be the year of the great reflation.

We didn’t have long to wait for answers.

According to Bloomberg, the first three months of 2021 marked the worst quarter for US Treasury performance since 1980. Why? Fears of rising inflation, of economic recovery, of unemployment falling, of huge fiscal spend, of an overbought market – take your pick. The yield offered by the 10-year US bond rose from around 1% to 1.65% between 1 January and 31 March.

Across the G7, government bond prices moved in the same direction – downward. The magnitude of the move in each jurisdiction was governed by three intertwined factors, namely the pace of the vaccine rollout, subsequent reopening of economies and attendant expectations for ongoing central bank support.

With half the UK adult population at least partially vaccinated by the end of March, gilts performed especially poorly. The UK government also tends to borrow for longer periods than most other G7 nations, making their bonds more susceptible to changes in rate expectations. Still, the near 8% fall in gilt indices was an unpleasant surprise for many.

Contrast that with Germany. With much of the continent moving into fresh lockdowns, the outlook for economic growth in 2021 appeared to weaken. Bunds still lost money during the quarter despite firm expectation of more ECB support.

The Bank may need to tread carefully: by February 2021, German inflation had reached 2% year-on-year as energy prices rose and structural forces came into play – and when that adjustment was made to ‘nominal’ losses, the real losses to those who bought 10-year Bunds in March 2020 was more than -5%.

The worst quarter in 40 years for Treasuries, gilts down nearly 8% and 10-year Bunds falling 5% in real terms – were there any safe havens?

Risk assets generally did well in the first quarter of 2021. Swifter, stronger, stimulus-led economic activity pushed many major stock market indices to record levels. High-quality investment grade corporate bonds lost value as they are tied to sovereign bonds but losses were well below that on the underlying government debt.

Of the major components of the bond market, only high yield made gains. High yield is often only lightly correlated to government debt during periods when the economic cycle is changing. And, as is normally the case, the majority of returns came from income.

It was a mixed bag for more peripheral bond markets. Emerging market debt didn’t fare well: rising US yields and a stronger dollar are not good for emerging markets capital flows or for debt service capability. Yet higher risk markets, such as junior bank debt and hybrid capital securities, performed strongly – equity-like characteristics served them well at a time of ‘risk on’, although it again raised the question of whether those seeking bond risk and portfolio diversification are properly served by such instruments.

The forces that drove returns in the first quarter of 2021 remain in place. Yields are low but have risen as global economic activity looks set to advance. Central banks have been content to allow yields to rise but have served notice to investors that a more substantial sell-off will not be tolerated – for now. That sounds a clear note to herald the advance of risk assets, current prices notwithstanding.

Growth and inflation expectations continue to be revised higher, boosting market prices, and only when central banks deem that enough is enough when it comes to free money will we likely see a retracement.

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David Roberts
David Roberts
David Roberts joined Liontrust in January 2018 from Kames Capital to co-create the Liontrust Global Fixed Income team. David was previously Head of Fixed Income at Kames Capital and since 1988 has also worked at Britannia Investment Managers and Lloyds Bank.

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