The Pride - Issue 5 - Autumn 2021 - Magazine - Page 10
CO VER S T O RY
How does all this impact bond investors
and their portfolios?
Core to deciding whether to buy any
asset is to develop an understanding
of the risk versus the reward. Bonds
are generally viewed as a “safer” asset
class. In return for this perceived safety,
investors are not supposed to expect
material gain (or loss!). Rather, if we
can preserve our store of value, we are
normally reasonably happy.
Investors have enjoyed
the past decade worth of
central bank largesse as
much as anyone.
Unfortunately for investors, some bonds
just do not look worth the risk. The UK
government bond market – commonly
known as the gilt market – is a classic
example of this.
Historically, when we lent money to the
UK government, in return we received a
yield (the interest or dividend received)
that compensated for the corrosive
impact of inflation. Since the GFC, QE
and market manipulation, investors have
only been compensated to that small
extent around half the time. Indeed,
buying gilts today and holding them for
10 years means you would lose more
than 10 per cent of your real value if
inflation meets, never mind exceeds, the
Bank of England’s 2 per cent target.
The chart above shows that lending to
the UK government actually costs money
when adjusted for inflation; government
bonds offer negative yields in real terms.
As we know, the lower the yield on
a bond, the higher the price. Bond
investors have enjoyed the past decade
worth of central bank largesse as much
as anyone. Yields for UK and European
investors remain close to all-time lows,
prices close to all-time highs. Of course,
prices could go a little higher, but against
this stable economic backdrop there is a
chance prices could start to fall – a lot. I
could fill this article writing about Brexit
and why this means gilt yields should
be low. I won’t – I will simply suggest
that if Brexit is “bad” then sterling will
fall and we will have inflation (see 2016
as an example). If Brexit is “good”, the
10 - T HE P R I DE - Issue 2 Winter 2018
Gilts less inflation
6%
5%
4%
3%
2%
1%
0%
-1%
-2%
-3%
-4%
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
Source: Bloomberg, UK 10 year gilt yield minus consumer price inflation
economy will perform well and the Bank
of England will raise rates. Either way,
gilts should lose value.
Perhaps the best lesson for bond
investors from the recent past is to
look at what has happened in the US
market. As the Federal Reserve began
to walk away from the market two years
ago, yields rose. Back in July 2016,
10-year maturity US bonds had a yield
of 1.35 per cent. By late July 2018,
this yield had risen to 2.95 per cent
- representing a capital loss of around
15 per cent!
So some bonds are expensive, should
we just avoid the asset class altogether?
However you look at them, some bonds
are very expensive and offer investors
poor nominal returns and negative real
(after inflation) returns. Although many
portfolio managers must own expensive
bonds, perhaps because they track a
benchmark or an index or worst of all
“because their peers do”, there are
many who can avoid expensive bonds
and look for cheaper and hopefully no
more risky alternatives.
Unfortunately, I’m old enough not just to
remember the 1990s, but also to have
been working in markets before that
decade started. Back then, gilt investors
often were paid around 2 per cent or 3
per cent more to own UK Government
bonds than US Treasury ones. Today,
we are paid nearly 2 per cent less to
own gilts – whether this is the result
of market manipulation, QE or Brexit.
Of course, for existing holders of gilts,
this is great because prices are up.
For new investors, this is not so good.
For investors, it is not as simple as buying
the US market and taking a much higher
return. Buying US Treasuries means you
need to buy US dollars and this can
be costly and risky – as too is hedging
out the foreign exchange risk! The
chart on page 11 shows how some of
these bond market relationships change
over time and of course highlights
how expensive the UK market really
is. Some bond funds can, of course,
seek to exploit these differences and
inefficiencies for investors.
We now need to be aware
QE has ended in the US
and the UK is in the process
of doing the same.
And if gilts start to move back towards
more normal levels, what does this
mean for holders of the bonds? Well, at
present UK five-year bonds yield 1 per
cent and 10-year bonds yield 1.3 per
cent. Should each move to 2.4 per cent
(in line with prevailing UK inflation), this
could represent a capital loss for the fiveyear bond of 6.5 per cent and 9 per
cent for the 10-year bond.
An actively managed fund will probably
seek to limit capital loss, buying the fiveyear maturity. An active and flexible fund
will probably avoid the UK altogether
and buy the US where, as I said earlier,
capital values have in some cases
already fallen 15 per cent.