The wobbles in the gilt market last week may have brought back some unhappy memories for some. The 24% average drawdown for gilt funds in 2022 is still raw for many investors, who do not buy gilts expecting to be on the edge of their seats.
So could this be another nerve-wracking year for fixed income markets and, if so, how are asset allocators positioning themselves?
The problems in the gilt market have threatened a full-blown crisis for the government and have drawn comparisons with the turmoil surrounding the Liz Truss ‘mini budget’. In reality, this has been a slower burn problem, with the 10-year gilt rising from 3.8% in September to 4.9% today, as fears over higher inflation and lower growth have crept into bond markets.
The UK bond market is not out of sync with other bond markets. Over the same period, the US 10-year treasury yield has risen from 3.6% to 4.8%. Even the German 10-year bund has risen from 2% to 2.6%.
Bond markets appear to have reacted to the US Federal Reserve’s hawkish statement in December, saying that a complete U-turn with rate hikes next year can no longer be ruled out. They are also nervously anticipating president-elect Donald Trump’s policy agenda, which looks set to be inflationary.
However, rising inflation is not an inevitability. Trump will be aware that President Joe Biden’s unpopularity was, in part, owing to inflationary pressures and may curb his plans accordingly. Equally, while Trump’s policies may prove deflationary for the US, high tariffs could weigh on growth elsewhere.
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Anthony Willis, investment manager in the multi-manager team at Columbia Threadneedle, pointed out it is possible to make diverging arguments for the year ahead.
“It’s quite easy to paint both bullish and bearish arguments,” said Willis. “On the bull side, there may be market-friendly outcomes from President Trump, positive political moves in Europe and maybe some pragmatism in Europe over government debt as well as stimulus from China reigniting the economy.
“Trump tariffs could prove more talk than action, and some kind of peace may prevail in Ukraine. Central banks could cut rates as inflationary pressures subside even further.”
However, he added, the alternative scenario incorporates a trade war, a stagflationary environment, persistent political gridlock in Europe, China failing to get out of the doldrums, and central banks unable to cut rates because of ongoing inflationary pressures. For the time being, Willis expects to see rate cuts over the year, but believes it won’t be long before central banks move to a more ‘wait and see’ type stance.
This makes for an unpredictable environment in bond markets and asset allocators are taking very different views on bonds. For example, Willis said the BMO team is neutral on fixed income across its portfolios, with a preference for high yield bonds and investment grade over government debt.
In contrast, James Calder, chief investment officer at City Asset Management, is backing away from high yield across the group’s portfolios believing spreads leave insufficient margin for error. He said fixed interest could play a more prevalent role in portfolios in the year ahead, particularly lower risk portfolios.
“A skilled fixed interest manager with an active mandate should be looking at returning at least 6%,” said Calder. “If we can agree that the long-term return of developed market equities is in the 7-8% range (it will be more or less depending on the near-term backdrop) 6% for a lot less volatility is attractive.”
For the time being, he is sticking with strong strategic bond managers, who can allocate flexibly between sectors.
Ian Rees, head of multi-manager at Premier Miton, said there is no reason to worry on US or UK debt just yet.
“The main factors surround the sustainability of UK and US government borrowing,” he said. “It is likely that the UK Labour Party will have to change its current fiscal stance, either through lower spending or higher taxes, with the former more likely.
“The Bank of England will be focused on financial stability and may intervene in the bond market in one of two ways, either interest rate cuts or quantitative easing. The most likely starting point for the BoE would be to signal change and observe reaction.
“In the US the story is similar, with worries that Trump’s spending is unsustainable but also the inflation dynamics will be significantly higher based on the strength of the economy.”
For the Premier Miton team, this represents a buying opportunity for government bonds. They see yields of about 5% as attractive and if there is any form of intervention or, in a worse-case scenario, a slowdown in the UK/US economy and rates are cut, they believe these bonds could rally.
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Laith Khalaf, head of investment analysis at AJ Bell, agreed this is not on the scale of the 2022 crisis in bond markets.
“Existing bond investors will be nursing some modest losses as a result of the latest sell-off,” he said. “The typical gilt fund is down 2.5% in the last three months, while the typical pension lifestyling fund is down 4.4%, as these invest in longer dated bonds.
“To put this in some context, in 2022 these funds fell by 24% and 36% respectively. We’re very, very unlikely to see such deeply negative returns given yields are starting from a much higher level, and bonds are also now paying some income, which can offset capital losses.”
He added new bond investors might be “licking their lips” as yields rise and they are able to lock into higher rates.
Bryn Jones, head of fixed income at Rathbones, said there might be more pain in the short term with UK gilt auctions over coming weeks, if the £2.3bn auction of 30-year gilt at 5.2% is anything to go by. However, he added the forward Sharpe ratios of gilts suggests they have not been as attractively valued in decades.
This is far more volatility than investors might wish for in the ‘low volatility’ part of their portfolio at the start of a new year. However, a repeat of 2022 looks unlikely, and asset allocators are even finding some bargains amid the rout.
