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Bond investors seek a refuge

Tough questions are back for 'safe' bonds
October 14, 2021

With the inflation narrative continuing to gather momentum, life has looked pretty hairy for bond investors. As we moved into the first full week of October the yield on a 10-year UK gilt hit its highest level since spring 2019 on the back of soaring gas prices. This followed a month in which resurgent inflation worries had already dealt a blow to government bonds elsewhere: US Treasuries have also seen yields spike and the FT reported a dismal September for conventional 60/40 portfolios as stocks and bonds fell in tandem – a worrying development for assets that are meant to have little or no positive correlation.

With fixed-income markets having shrugged off inflation concerns earlier this year and some prominent bond fund managers once appearing adamant that price rises should prove transitory, this represents a change in tone. Inflationary signals seem to be enduring and central banks appear more open to the idea of raising rates in the future, putting the asset class once again under pressure.

We’ve noted before that government bonds are often portrayed as a bubble waiting to burst, although they have continued to rise in price despite such predictions. As Laith Khalaf, head of investment analysis at AJ Bell, recently noted, it was back in 2010 that renowned fixed-income investor Bill Gross declared that UK gilts were sitting on a “bed of nitro-glycerine”. If Gross was early in this call, the subsequent gains in gilt prices now mean valuations have much further to fall. Khalaf notes that a 10-year gilt offered a yield of 4 per cent back when Gross made his remark: around a decade of strong performance later, it sat at roughly 1.1 per cent even in the wake of the most recent sell-off.

Investors again have to ask themselves whether 'safe' bonds such as government and higher-quality corporate debt will offer diversification from equities and whether they hold a good mix of defensive assets. The likes of alternative assets (from infrastructure to property and more esoteric options) may offer hope, although some classic safe-haven assets such as gold have had a difficult 2021.

With government bonds having defied many dire predictions in the past, it remains unclear what will happen in another major equity sell-off. Their status as a safe haven could hold up – but rising rates and inflation may challenge this. Many theories abound, and even some investors who expect the most obvious forms of inflation to abate are downbeat on the likes of gilts and Treasuries.

Take a recent note from Capital Economics. Oliver Jones, a senior economist at the firm, suggests that while a surge in energy prices will put upward pressure on government bond yields in the shorter term simply because investors expect greater compensation for holding them, it could be a different problem that emerges in the longer run, especially for the US market. He notes that while energy prices could fall back over the course of 2022, domestic price pressures in the US could remain strong, reflecting factors including the effects of the pandemic on the labour market. As such, we could see “energy prices gradually falling back from their current highs over the next few years, but US inflation compensation and Treasury yields drifting upwards as core inflation there stays higher for longer than is widely anticipated”.

For the time being, there are some solutions at hand for bond investors. They can limit their portfolio’s duration, or sensitivity to interest rate changes, whether by steering clear of government bonds or seeking those with shorter maturities. Some “inflation-proof” fixed-income investments remain a mixed bag: as we’ve noted, inflation-linked bonds do well on the back of rising inflation expectations, thanks to the link their interest payments have to price metrics. Yet they often have a good level of duration, spelling trouble if interest rate rises become more likely.

The rest of the bond space is also worth monitoring if inflation remains a problem. As we have previously noted, the likes of high-yield bonds have so far shown greater resilience in the face of inflation worries and concerns about rate rises. Last month, Janus Henderson’s global head of fixed income, Jim Cielinski, even cited Morgan Stanley research suggesting that bouts of rising inflation could often be positive for investment-grade and high-yield bonds, at least in the US. As Cielinski adds, inflation can also accompany improvements in economic conditions, aiding issuers of corporate debt.