According to the Wall Street Journal, 2022 thus far has been the worst year for US government bonds since 1842. Other bond markets have fared no better. The driver has been a complete turnabout in the inflation, and therefore the interest rate, landscape. Investors have demanded higher yields on bonds – driving prices down. After such falls, and with interest rates continuing to rise to address what looks like a stubborn inflation problem, investors should quite rightly be asking themselves why they are bothering with bonds at all. In this note we look to answer this question by considering the economic outlook and the possible path of inflation, interest rates and bond yields from here.
However, we begin with some bond background.
Bonds
Bonds warrant a place in portfolios because of their reduced correlation with riskier assets, the low volatility they typically exhibit, and the return above cash they usually provide. They ought to be straightforward. A simple, fixed annual coupon is paid on the capital sum borrowed, with that sum repaid on the agreed maturity date. Even greater simplicity is achieved if the bond is issued by a government which, being able to issue more currency to repay it, is highly unlikely to fail to pay the coupons or repay the capital. There is effectively no default risk. The challenge comes with the erosion of purchasing power of the cash sums, returned via coupon and capital, by inflation. If inflation is diluting away the purchasing power of bond holders, they demand compensation – in the form of higher coupons on new bond issues. Those bonds already in issue fall in price – so that they offer a yield competitive with new bonds issued with higher coupons. This is the simplest of explanations for recent bond market weakness. It is important to note, however, that these falls in bond prices do not mean that the flow of payments from the bond will decline or stop altogether, only that the bond prices have fallen to reflect the higher yields demanded by investors. We now consider the experience of bond markets this year and the underlying economics.
Bond woes, economics and the path ahead
This year’s bond market woes were triggered by the surge in inflation which began late last year, and the increasingly aggressive interest rate tightening cycle pursued by central banks to address it. It now seems likely that by the end of the year, US interest rates will be around 4%. As recently as March they were zero. Interest rate increases of this rapidity and magnitude are beyond extraordinary and with more interest rate increases to come, surely investors should be confining bonds to the bucket labelled ‘not with a barge-pole’?
Before attempting an answer to this question, we should issue a mea culpa. We did not believe that inflation would, or could, become the issue that it has. Along with many central bankers, we were in camp ‘transitory’, believing that the inflationary impulses – the product of covid-related supply disruptions – would pass through the global economy without leaking into other areas. In taking this view, we were not unthinkingly following the central bank line. Our rationale was based on the fact that, after a very long period of very low interest rates, the world economy had become very, very indebted and would therefore be extremely sensitive to higher interest rates. To us this meant that faced with rising rates, economies would slow very quickly – easing inflationary pressures and removing the need for interest rates to go up far, or for long. In short, we believed that small interest rate increases would trigger slowdowns which would ‘cure’ any inflation and allow interest rates to fall back again. Anything else would spell great difficulty for consumers, companies and governments alike.
So much for that theory. Inflation remains stubbornly high – forcing central banks to impose the enormous interest rate hikes we’ve seen in recent weeks. Despite this, so far labour markets have remained strong, wages are growing and, as we write, a report has been issued by the UK’s Office of National Statistics showing that house prices rose by 15.5% in the 12 months to the end of July.
So, is it the case that ongoing interest rate increases are fully warranted – and inflation is not going to fall back any time soon? If this were the case, bonds should definitely be avoided. While this narrative makes sense on first inspection, we do not believe it is correct. Beneath the surface, higher interest rates are already hurting economies – and the pain has barely begun. Housing markets are souring. The share prices of UK house builders have halved this year while in the US, mortgage rates are now 6.4%, much more than twice what they were a year ago. Unsurprisingly, given higher mortgage rates are being charged on much bigger mortgages, forward looking housing market metrics are swooning. Many other indicators are flashing warning signs and sentiment indicators and surveys are slumping. Lagging indicators including employment, and indeed inflation itself are, we believe, set to follow. The chart below shows the historic correlation between the NAHB index, a US housing market outlook survey where readings below 50 indicate a poor outlook, and the US labour market 18 months later. The relationship is extraordinarily clear. It suggests much higher unemployment in the coming months.
Bringing the discussion back to bonds, yields have already risen significantly to reflect the further interest rate rises that central banks are expected to deliver. The economic landscape set out above suggests that the high point for bond yields is nearing. Bonds do well when interest rates are falling – this tends to occur when the economic outlook is poor, because the secure coupons paid by government bonds are attractive relative to the alternatives. In our view, the outlook is indisputably poor. The rapidly deteriorating economic environment is the reason that we have put through significant cuts in equity weightings. It is also why we are trying to be patient with bonds. They are paying coupons and offering yields far higher than was the case a year ago – thus there is some compensation for our patience. High-quality government and corporate bonds will also typically repay the borrowed capital sum in full upon redemption (default rates over the last 40 years have been inegligible).
Our second chart shows a brief history of the relationship between interest rates, inflation and recessions. Interest rates are increased to deal with, or head off, rising inflation. Higher interest rates slow the economy, often to the extent that it enters a recession (shown as the shaded areas). When the inflation dragon is slain, interest rates are then cut – and a new economic cycle begins as growth resumes.
In short, bonds are now offering investors with increasingly attractive levels of income as an alternative to riskier assets. As we have reduced our exposure to equities in light of the deteriorating economic backdrop, we have, for now, been increasing our allocations to bonds to take advantage of these more attractive yields. Some of the short-dated bond funds that populate portfolios are offering investors an income of c4%. Meanwhile, with central banks resolutely focused on bringing down inflation by slowing their economies, many of the fund managers and economists we meet see good value in fixed income, with high-quality bonds likely to prove defensive amid an environment of sustained economic weakness.
