11th February 2022
Having hit an all-time low in the summer of 2020, bond yields have been on the rise ever since, with the pace of travel gathering particular momentum in the past few months. Indeed, the benchmark UK government 10-year gilt currently yields 1.46% up from 0.10% in late July 2020, a not insignificant shift of 136 basis points. A similar story has played out in other markets. In the US, 10-year Treasuries currently trade with a yield of 1.95%, a post pandemic high, whilst German Bunds are offering a positive nominal yield for the first time in almost 3 years.
The inverse relationship between bond yields and bond prices means that recent moves higher in the former have resulted in a significant hit to capital values. Longer dated bonds with low, fixed rate coupons have greater sensitivity to changes in yields than shorter maturity bonds with higher coupons and are therefore more susceptible to losses when yields rise. This interest rate sensitivity, also known as ‘duration’, is a mathematical concept that enables investors to calculate the potential losses or gains that a parallel shift in the yield curve would inflict on their bond portfolio. The longer the duration of a bond, the bigger the impact. A bond with a duration of 10 years would, for example, experience a 10% capital loss for a 1% increase in yields. This is slightly oversimplified and doesn’t take account of convexity, but hopefully illustrates the negative impact that rising rates can have on capital values.
In the recent era of low rates, bond issuers have been well incentivised to extend maturities and lock in low finance costs for as long as possible. This has resulted in a marked increase in the duration of the major bond indices. For investors however, lower yields and longer duration means less return and more risk. Unfortunately, those very same indices form the basis of many exchange traded funds whose job it is to replicate the returns of an index in as cheap a way as possible. As a result, investors accessing bonds via passives, are likely to be subject to a higher degree of interest rate risk than they perhaps realise.
The UK government bond index, for example, currently has a duration of 17.7 years, the index linked gilt index 22.4 years and the sterling investment grade credit index a duration of 10.5 years. Looking at one well known multi-asset passive solution that offers cheap exposure to large, liquid fixed income and equity markets at low cost, reveals a bond portfolio with a duration of 11.4 years. Yield increases of 1% or 2% would inflict capital losses in excess of 11% and 22% respectively on that component of the portfolio and would be materially detrimental to portfolio returns as a whole. A more cautious investor might have say – 60% of their overall portfolio in bonds, which as a result of their lower volatility are regarded by large swathes of the asset management industry as lower risk investments. The bond component in this example would, all else equal, result in portfolio level losses of almost 7% and 13% in the yield scenarios painted above. These sorts of return profiles, and the experiences of the past year or so (UK Government Bond Index -11.8% since 1st August 2020) don’t scream low risk to us even though bonds might lose you money in a smoother way than other asset classes.
We have long been wary on mainstream fixed income markets. This is not predicated on any strong macro views, and we certainly don’t make investment decisions based on hard to forecast macro variables like where inflation might be headed or what central banks might say or do in the coming months. We do think that the probability of inflation being higher than it has been over the course of the last decade has increased and it is therefore right that bond yields should move higher to reflect this increased volatility in likely outcomes. The prime driver of our caution, however, has been valuations. Let’s return to the 10-year gilt of July 2020, yielding a paltry 0.10%. What does that level of return do to help meet client and investor objectives who at the bare minimum should be seeking positive returns through the cycle when adjusted for costs, taxes and inflation? We also worry that with yields so low, the efficacy of government bonds as a hedge to equity risk in multi-asset portfolios is much diminished. This is not an idle concern emanating from how we think the future might play out but instead is rooted in the bond math’s. Take the classic 60% equity, 40% bond portfolio and assume that the bond element of the portfolio has a duration of 10 years and a current yield of 1.45% (i.e. broadly in line with the current yield of the 10 year gilt): for the bond component to offset say a 20% correction in the equity element of the portfolio, the bond yield would have to drop to -1.5%. Yes, that’s a negative number, and yes that’s in nominal terms. Possible, but highly improbable in our view. Furthermore, we also worry that low interest rates are being used in some quarters to justify high equity valuations and that a rise in bond yields could be the catalyst that ends the current equity market complacency. We are already seeing evidence of this with the recent back up in bond yields ‘coinciding’ with a dramatic sell off in aggressive growth stocks. If this gathers pace, then the negative correlation between equities and bonds that underpins the portfolio construction principles of the 60/40 portfolio will be wholly undermined. It’s also worth recognising that there is precedent here and market history is replete with examples where equities and bonds have exhibited positive correlation for extended periods of time.
The paltry returns and lack of value in mainstream bond markets has resulted in our funds having low and very differentiated exposure to fixed income. Our Distribution Fund, for example, has just 13% in bonds whilst Vanbrugh, which as a result of its inclusion in the IA Mixed Investment 20-60% shares sector has to have a minimum allocation to fixed income and cash, has exposure of 23%. Crucially the nature of our bond allocations are very different with low exposure to large, longer duration government bond and investment grade credit markets and high exposure to floating rate securitized credit where the floating rate structure means the coupons paid to investors increase with short end rates (LIBOR, SONIA). Our investments in private debt via investment trusts also typically carry shorter maturities and often enjoy LIBOR linked coupons. This focus results in duration on the bond component of Vanbrugh and Distribution (Global Opportunities has 0% in fixed income) coming in at around 3.5 years and 1.5 years respectively, significantly lower than that exhibited by the passive multi-asset example discussed earlier.
Recent months have highlighted how much damage supposedly lower risk bonds can cause, especially when they are longer duration in nature and when they form a significant allocation of an investor’s overall portfolio. Despite the sell-off, real yields are still deeply negative and the likely returns from mainstream bond markets remain uninspiring to say the least. With inflation and rate expectations more volatile than they have been in decades, the benefits of active management within fixed income markets have arguably never been greater.
Ben Mackie – Fund Manager
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