Having got accustomed to a bull market in high quality bonds for the whole of my investment career, I am rapidly having to adjust to a new bond market landscape.
It’s not easy for someone weaned on seemingly ever declining bond yields. Market rates of interest, as opposed to the Bank of England’s base rate, troughed in the summer of 2012 and have, more or less, been rising ever since. That rise has been particularly rapid in recent weeks with ten year gilt yields having increased by well over 100bps in less than five months.
It’s not that we hadn’t been anticipating gilt yields to rise over the longer term; indeed we had been expecting it somewhat sooner. But the pace of the move has undoubtedly caught us by surprise.
Before considering the implications for bond investors, it’s worth reflecting on why we have seen such an abrupt move higher over the summer.
Since that low point in mid 2012 two things have changed which have impacted the UK government bond market. Firstly, the Euro-zone is no longer on the verge of implosion. Implicit in those exceptionally low yields of mid 2012 was a premium for the risk that the Euro-zone could collapse. A little over a year later, that risk appears significantly reduced. Secondly, and perhaps more importantly, the domestic economic outlook has, finally, started to improve. After stumbling through the years since the financial crisis, the UK economy is starting to get on its feet again.
Although Mark Carney has insisted the Bank will keep the base rate on hold for some time, investors have started to discount future tightening of monetary policy to reflect the improving outlook. It is the pace of this economic recovery, and investor’s expectations that it will continue, which is primarily responsible for the sharp correction in gilt yields.
What has this meant for bond investors? The flippant answer is it depends on why you hold them. For investors who hold bonds as a match against their liabilities – pension funds, insurance companies, and the like – then significant implications from a quickly rising interest rate market don’t appear that apparent, especially over the longer term. There is much more to consider for those investors who are looking to generate income or total return. The vast majority of dedicated bond funds will struggle to generate a positive total return during a period of rising interest rate expectations, given the inverse correlation between bond yields and prices.
However, there are ways to help compensate for the headwind of rising interest rates. Reducing duration (the sensitivity to interest rates), allocating to specific sections of the bond market (high yield, investment grade credit, etc), can all can help to balance out the impact of interest rate rises. Generally the more flexible the mandate of a bond fund (the more tools it has its disposal), the greater its ability to offset rising interest rates. This is evidenced by relative bond fund returns over the last 6 months (a period where ten year gilt yields have increased by approximately 100bps). The median ranking fund in the IMA Sterling Strategic Bond sector, where the vast majority of the more “flexible” funds sit, has returned -0.5 per cent in that period. Not a compelling total return by any means, but more palatable than the -4.7 per cent generated by the median fund in the much more constrained IMA UK Gilts sector.
Taking a step back, there are also higher level considerations. Although periods of rapid increases in interest rate can have painful short-term consequences for bond investors, there is an argument that a quicker return to more normal levels of government bond yields would be better for the overall well-being of the market. A long, slow, rise in market rates of interest would give less volatility in total returns, but could be something of a death by a thousand cuts as investors hesitate about committing capital to the market. Whereas, perhaps the best outcome for their long-term health is for bonds to return as swiftly as possible to what they have been for the vast majority of their history – a diversifying, low-risk, incoming generating asset class.