The bond surprise that has caught investors out – and what to do about it

Bond surprise

The start of 2014 has caught investors (both professional or private) by surprise. Investment experts and commentators were almost unanimous in decreeing the end of the bond bull market at the start of the year. But year-to-date 6 out of the 7 top performing sectors are bond/gilts (see table at the foot of this note). So what’s happened?

In this note I look at

• whether bond sceptics were wrong to call the death of bonds?
• why has index linked gilts been the top performing sector
• should investors hold onto their bond exposure?
• why the’ smart money’ (institutional investors) has been rotating from equities to bonds?
• plus where are the bond opportunities for investors?

Why bonds have outperformed in 2014

First of all, 2013 was an excellent year for equities, the FTSE 100 alone rose 18.66%. In contrast, 2013 was the worst year for gilt markets since 1994 and the second worst in nearly 30 years.

But what drove equity markets was Price/Earnings (P/E) expansion and not earnings growth. So equities simply became more expensive during the course of 2013, as measured by P/E. By way of comparison, 2013 was a poor year for fixed income investor, the average UK corporate bond fund made just 0.64%.

As we entered 2014, gilt yields had increased to such an extent that the gilt market was pricing in a base rate of 3% before the end of 2016. But then came the reality check…..

Reality check

While it is true that wages have been growing less than inflation, for consumers who have held onto their jobs their ‘pay net of mortgage expenditure’ has been buoyed by low interest rates. But with approximately ⅔ of mortgage borrowers now paying mortgage interest based upon their lender’s SVR (standard variable rate) their disposable income will be directly affected should the Bank of England raise its base rate. Which in turn will slow the UK economy.

Mark Carney, the Governor of the Bank of England Governor knows this, which is why back in December Carney he hinted that monetary policy was the last line of defence, particularly in any attempt to cool the housing market.  Instead he hinted at other potential cooling measures, such as imposing stricter capital reserves on banks’ riskier mortgages lending.

The market took this on board and it is little wonder that the gilt market cut its predicted base rate at the end of 2016 to between 2-2.25%.

Other bond drivers - and the rotation myth

Add into the mix that as equities had become comparatively more expensive the  incentive to sell bonds and buy equities had diminished by the start of 2014.

In addition, unlike early 2013, gilt yields were finally more attractive than deposit rates, so discouraging investors to sit on cash. Gilts looked better value as we entered 2014 encouraging institutional buying.

Furthermore, the European Corporate Bond market (which includes the UK) has been shrinking over the last four years, yet pension funds across Europe still need to provide a stable income source to an ageing population. So large Life and pension funds took the opportunity of cheaper fixed income opportunities to actually rotate some of their 2013 equity profits into bonds/gilts. In fact, the exact opposite of the once much anticipated ‘Great Rotation’.

The net result was that fixed income assets actually rose, also helped by bouts of risk aversion while developed world equity markets traded sideways

So why have index linked gilts outperformed while inflation expectations have fallen?

In reality inflation is not the main driver for Index Linked (IL) gilts’ investment returns. Approximately 90% of upward movement for IL is driven by the normal gilt market. IL tend to have a longer duration so they outperform in a strong market for gilts, which early 2014 has been.

So are there opportunities in bonds?

As a result of the market movements year to date

• Gilts are now expensive

• The chase for yield means that Investment Grade bonds are now more attractive from a risk/return perspective than High Yield bonds.

2014 so far has shown how the consensus can be wrong (again) and also why diversification into bonds can aid overall portfolio returns. But what has driven the bond market over the last 5 months could also reverse (as can be seen by the moves in peripheral European debt last week as political risks took the spotlight).

The call of the ‘death of the bond bull’ was premature but it is still seems inevitable. Those funds which have performed the strongest year to date are typically those with the longest duration. So performance chasers need to keep on their toes, because if interest rate / inflation expectations suddenly shift they could be left licking their wounds.