UK bond yields spike - what it means for investors

• The benchmark 10 year gilt yield has now surged past 1.1%, the highest level since the spring of 2019
• It has more than doubled from 0.5% in the last two months
• Inflation and expectations of interest rate rises have led to the sell-off
• Are UK gilts now sitting on a ‘bed of nitroglycerine’?
• The pension investors sleepwalking into gilt investment

Laith Khalaf, head of investment analysis, AJ Bell:

“Bond might be taking the cinema scene by storm, but it’s no time to buy bonds on the capital markets. Energy price rises are giving markets the jitters, inflation is on the rise and central banks are talking about tightening monetary policy, all of which has led to a sell-off in UK gilts. The yield on the benchmark 10 year gilt has risen from just over 0.5% two months ago, to around 1.1% today. The rise has been pretty sudden, but 1.1% is still historically an incredibly low rate, below the target rate of inflation, which means that investors remain willing to accept a negative real return for the sanctuary of government bonds.

“This may prove to be a false sense of security for gilt investors however, if we really are entering a new era where interest rates are on the up, and QE starts to be unwound. Although the gilt yield has only backed up a bit, some UK bond funds have sustained double digit falls so far this year. While that’s probably not enough to make most equity investors blush, investors choose bonds because they’re seen as safe havens. But twelve years of ultra-loose monetary policy has driven gilt prices so high, they now carry an awful lot of valuation risk, and offer a desultory yield in return.

“In 2010 the bond guru Bill Gross said that the UK gilt market was sitting on a ‘bed of nitroglycerine’. He was wide of the mark, but he may just have been a little early in his forecast, to the tune of a decade or so. At the time of his comments, the 10 year gilt yield was sitting at a much more normal 4%, before the scars of the financial crisis really made their longevity known, before Brexit prompted another shock interest rate cut, and of course before the pandemic resulted, inconceivably, in even looser monetary policy. Today the yield on government debt is significantly lower than a decade ago, which means the explosive power of tighter monetary policy, and any ensuing sell-off in the gilt market, would be even more damaging for government bond investors.

“Rising interest rates would also be extremely negative for government finances, where debt costs have been supressed by loose monetary policy. This is particularly poignant because the QE programme has effectively pegged £875 billion of government debt to the base rate, which is a floating interest rate that can change overnight, rather than locking into the longer term fixed rates of the gilt market. In its Budget forecasts in March, the OBR estimated that if interest rates were 1% higher, that would add £20.8 billion to the government’s debt interest bill in 2025/26. To put that in some context, that would wipe out all the £8.2 billion gain the Treasury expects from freezing income tax allowances, as well as a sizeable chunk of the £17.2 billion projected to roll in from the rise in corporation tax.

“As Bill Gross amply demonstrated, it’s unwise to try to predict the future, but prudent to consider the balance of probabilities. Right now, demand is outstripping supply in many markets, and the resulting inflation appears to be the big risk in the global economy. Even if it proves to be transitory, a bout of inflation is still extremely negative for the fixed income streams provided by bonds. If inflation persists, it’s even worse. On the other hand, there is a chance that the global economic recovery will stutter, that inflation will fall away, and central banks will ease back on talk of tightening policy. In that scenario, bonds will rally again. But even then, it’s a stay of execution rather than a pardon. Unless we believe that monetary policy will never normalise, and that QE is here forever, there must come a day of reckoning for the bond market. It’s a question of when, not if.”

Risk is in the eye of the bond holder

All bonds take their lead from the government bond markets, but there has been a wide dispersion in the fortunes of bond fund investors this year. The table below shows the performance of the main Investment Association and ABI Pension bond sectors so far in 2021. The ‘safest’ bonds have been the ones that have seen the heaviest sell-off, with some of the riskier sectors actually making positive returns. The longer term performance figures, showing returns in the ten years up to the start of 2021, demonstrate the tremendous ground made by bond funds as a result of loose monetary policy.

Unlike gilts, corporate bonds (both investment grade and high yield) carry a higher interest rate, which cushions the impact of price falls emanating from fears of tighter monetary policy. They also tend to be shorter dated, which means they are less sensitive to interest rate rises. Being loans to companies rather than governments, they also experience some upward pressure on prices from an improving economy, because the accompanying earnings growth should make it easier for companies to service their debt. In a rising interest rate scenario, these ‘riskier’ bond funds should therefore fare better than ‘safer’ gilt funds. Of course, if the economy takes a dive, it’s gilts which fare better than corporate bonds.

Source FE total return, 31/12/2020 to 05/10/2021 and 31/12/2010 to 31/12/2020

What should investors do?

In the current environment, those who hold bonds might consider moving their portfolio towards shorter-dated bonds, and indeed corporate bonds, if they are concerned about interest rate rises. Strategic bonds funds in particular are worthy of consideration. These have the flexibility to invest in government bonds, investment grade corporate bonds, and high yield bonds across the globe, giving the fund manager the scope to pick up a higher income where appropriate, and potentially protect investors from tightening monetary policy in certain regions. Index-linked gilts also offer investors some protection from inflationary pressures because their capital and income rises with RPI. However, they also tend to be long-dated, which means interest rate rises will take some toll on that uplift.

The pension investors sleepwalking into gilt investment

The ABI Sterling Long Bond sector is an interesting case in the table. This sector is made up of pension funds used for a process called ‘lifestyling’. As investors approach their stated retirement date, they are automatically shifted from equities into long dated government bonds. The idea is to hedge annuity rates, which move in line with bond yields. Of course, since the pension freedoms were introduced, very few people now buy an annuity. But these lifestyling programmes, potentially set in train 20 to 30 years ago, are still robotically moving people into gilts regardless.

Stakeholder pensions and older workplace pensions run by insurance companies are most at risk of having a lifestyling programme in place, and it normally kicks off five years before retirement. These are dangerous algorithms, because many investors will have been defaulted into these strategies, and won’t know what they are. These funds have performed very well in the last ten years because of loose monetary policy, but the long-dated government bonds these funds invest in are directly in the firing line of inflation and interest rate rises. Any falls sustained in the value of these funds should be offset by rising annuity rates. But then, that’s not much use if you’re not buying an annuity.

What are bonds good for?

There are generally three reasons investors choose bonds: income, safety, and/or diversification.

Income

The income from government bonds has been annihilated by over a decade of loose monetary policy. Most UK gilt funds are yielding less than 1%, which is a poor return given the risk to capital from rising interest rates, particularly when you consider investment charges and taxes may need to be paid too. Corporate bonds and high yield bonds pay more, so income-seekers could consider moving up the risk spectrum into these assets, or indeed into equities, where yields are higher.

Safety

UK government bonds are considered safe because they tend to exhibit low volatility, and an extremely low risk of default. If held until maturity, investors will almost certainly get their capital back, plus whatever yield they have picked up over the life of the bond. However, over that period the market price of the bond can fluctuate considerably, for better or worse, and that creates risk for those investors whose investment time horizon is not as long as the gilts they’re investing in.

For instance, lifestyle fund holders will typically be invested for only one to five years, whereas the funds they are invested in will generally be holding gilts with 10 to 15 year maturities, or longer. These investors are therefore exposed to market price risk when they encash. For investors who aren’t going to hold gilts to maturity, but want a safe home for their money, cash looks the only sensible alternative. The interest on offer isn’t much less than that offered by government bonds and unlike gilts, the capital value won’t fall if interest rates rise. Of course, it is still subject to the vagaries of inflation.

Diversification

Some investors also use bonds to diversify an equity portfolio. Right now this is probably the most useful of the three functions that bonds can perform. While the global economy looks set to grow, if this doesn’t prove to be the case, some bonds in a portfolio can help to add some ballast. This is particularly the case for those with shorter investment horizons. An investor with twenty or thirty years to go before retirement on the other hand, can be more sanguine about equity market falls, as they can simply wait for them to recover. There is little need for bonds, even though most pension default funds will contain them, no matter what your age.

There is a school of thought which says that gilts are best for diversification, because they have a lower correlation with shares. There is definitely some merit to this approach, but the present imbalance between risk and reward in the government bond markets suggests investors pursuing this strategy might wish to temper their gilt exposure by holding more short-dated funds. Alternatively, they may choose to switch some of their gilt holdings to Strategic Bond funds and accept they may have a more highly correlated portfolio, but have dodged some of the valuation risk in the gilt market.