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Our views 13 June 2022

JP’s Journal: The bond market

5 min read

James Carville, an advisor to President Clinton, was once quoted as saying: “I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a 0.400 baseball hitter. But now I want to come back as the bond market. You can intimidate anybody.”

I have to admit I don’t know what a 0.400 hitter is – but I do know that bond markets are big, important and, in the UK, under appreciated.

World bond markets are huge and exceed equity markets in size. But more than that, they price many instruments we take for granted. Mortgage rates are set by interest rates and bond yields. In consequence, what happens to bond yields has a massive impact on the valuation of residential and commercial property. In the pension world, actuarial valuations are dependent upon nominal and real yields. And in the equity world, future cashflows are discounted using long-term interest rates. As the National Institute of Economic and Social Research (NIESR) noted last week, what happens to bond yields also impacts government borrowing costs. Higher bond rates mean less money for the government to spend as more of the ‘pie’ is diverted to servicing debt.

So, what happens in bond markets is pretty vital and what we are presently seeing is a significant sell-off. This is driven by inflation and the fear of rising interest rates. And the implications? Housing markets are set to slow and perhaps go into reverse. As an aside, the UK government housing strategy is a mess. Listening to a respected economist on Radio 4 last week he referred to the potential reforms to the UK mortgage market as “economically illiterate”. I would agree. Have we not learned lessons from the Northern Rock 105% mortgages? The UK housing market is toppy and the UK government seems intent on making it worse – with taxpayers’ money. Negative equity is not something we hear of much these days – but we will if the government continues to favour tactical fixes over strategic thinking.

Impact of higher bond yields

In the real economy higher interest and bond rates mean not only less disposable income (higher mortgage payments, higher credit card bills), but higher financing costs for corporates as well as governments. One big change over my time in financial markets has been the replacement of equity finance by debt. The rationale is clear: the cost of debt is lower than the cost of equity (partly due to tax treatment). Over time companies have increased leverage (a higher debt / equity ratio) thereby increasing earnings per share. Investors have become more tolerant of debt and the cost of going down the rating spectrum has progressively got less penal. Or put another way: 30 years ago companies wanted to avoid sub-investment grade ratings because the impact on their cost of debt was material. Today, financing in sub-investment grade is just another judgement call to make. With all-in debt costs so low, from a company’s perspective, the numbers favoured debt over equity. Implications? More companies are going to go bust, having taken leverage too far, sunk by higher financing costs and a weak top-line.

But there is another story to tell. Credit is cheap despite the last paragraph. Long-term investors have fairly consistently been over-rewarded for taking credit risk over government risk. At the beginning of each year I ask myself: will sterling credit spreads narrow or widen? If they widen, will the extra yield I receive be enough to offset the impact of this widening. In effect, its either win or lose. But it is not a fair coin toss because the coin is loaded – you win more times than you lose. It is not quite so simple as the loss (material credit spread widening scenario) may be significant and could eat into the surplus accumulated by previous wins (stable or narrower credit spreads). Over time, however, the compounding impact of small wins is the basis of a successful long-term strategy. If you can bias the outcome even more in your favour, through good credit selection and a winning investment philosophy, you are in a strong position.

Inflation expectations

Will last week’s US inflation surprise change this? With core inflation at 6.2% I think the Federal Reserve is going to deliver 50bps rate rises until it sees a slowdown in prices. But financial markets are discount machines. With US 10-year yields back above 3% and an economic slowdown coming I am ditching my duration bearishness. My view had been that global yields were too low and would rise. They have now reached levels where I am broadly neutral. I am not bullish, as supply is coming down the tracks. But in my view, a lot of the over-valuation of bonds has been eliminated. If I am wrong, it is because I have under-estimated the resilience of the US consumer and under-appreciated ingrained inflationary pressures. What I do not see is continued stagflation. I do not see this as an equilibrium outcome.

Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.