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.
Key Risks
