The past five years have been a rollercoaster for fixed income markets. From the economic shockwaves of Covid 19 to the inflationary pressures of 2022, UK bonds have endured significant turbulence. Longer duration bonds, in particular, have faced the brunt of this volatility. However, as interest rates begin to stabilise and the Labour party emerging as the winner of the UK general election in July, what does the future hold for the performance of UK bonds?
Longer duration vs short duration bonds
Over the past three years, longer duration bonds have underperformed compared with their short duration counterparts. The key reason lies in the sensitivity of long duration bonds to interest rate fluctuations. With governments around the world hiking interest rates to combat inflation, the value of longer duration bonds eroded significantly.
In contrast, short-term bonds have returned positively over the same period. Their shorter duration means they are less sensitive to interest rate changes, making them a safer bet in volatile markets. High yield funds benefitted from their shorter duration, managing to outperform during the 2022 market correction. They also enjoyed risk-on periods such as reopening after Covid lockdowns and the rally in Q4 2023.
Inflation and equity markets
Inflation has been a significant factor influencing bond performance. Inflation-linked bonds and government bonds underperformed over the three- and five-year timescales. The longer duration of these bonds, coupled with volatile events like the Truss ‘mini-budget’ crisis in September 2022 created an environment ripe for underperformance. However, as inflation shows signs of stabilising, there is cautious optimism that these bonds could make a comeback.
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Equity markets have also played a role in shaping investor sentiment towards bonds. Big wins in the equity sector, particularly from growth sectors, have attracted capital away from bonds. However, this dynamic could change if equities become overvalued or if economic uncertainty increases.
Labour and UK bond performance
The introduction of a Labour government in the UK could add another layer of complexity. Historically, Labour governments have focused on fiscal policies that could influence bond markets in various ways. For instance, increased public spending could lead to higher bond yields, attracting investors seeking better returns.
On the flip side, Labour’s fiscal policies might also increase market jitters. Any drastic policy shifts could introduce short-term volatility, affecting investor confidence. With the market pricing in Labour’s general election win before the election (a scenario that materialised), and inflation on the edge of coming down, inflation-linked and government bonds may return to favour.
Fixed income market outlook
The fixed income market has had its share of ups and downs. Over the past year, returns have been positive across different segments, but volatility remains a concern. One-year returns have been positive, but key periods of volatility have caused returns to fluctuate significantly in the fixed-term bond market.
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Notably, Global High Yield GBP Hedged funds have been the only asset class to maintain positive returns over a five-year period (+2.81%), with a one-year return of 10.9% and a three-year return of 1.18%. High-yield’s outperformance has been driven by shorter duration, attractive yields, solid corporate earnings, low levels of default, and a more solid-than-expected economic environment.
Conclusion
As we look forward to the coming years, the UK bond market appears to be on a path to stabilisation. However, investors must remain cautious. External factors such as geopolitical conflicts and upcoming elections across the world including the US could influence economic policies and interest rates, potentially creating further volatility.
For UK investors and managers, understanding these dynamics is crucial. The new Labour government, coupled with stabilising inflation and fluctuating equity markets, will require a nuanced approach to bond investments. While short-duration bonds have shown resilience, keeping an eye on longer-duration, inflation-linked, and government bonds could offer opportunities as market conditions evolve.
In summary, the fixed income landscape is complex and multifaceted. By staying informed and agile, advisers can better position their clients to capitalise on the evolving market dynamics.
Evangelia Gkeka is senior manager research analyst at Morningstar
