As monetary tightening beckons, what might this mean for investment in bonds and bond funds? Brian Tora considers some of the issues involved
When the US Ten Year Treasury Bill yield breached 3% for the first time in over four years last April, American equities did not take too kindly to the news. The S&P 500 fell by more than 1.4% that day – hardly panic stations, but a clear indicator that higher yields would inevitably impact on share values. And, of course, higher yields in the fixed interest space lead to falling bond prices. Given the amount of money that a widening array of bond funds have attracted in recent years, watching the likely course of interest rates and fixed interest yields is now essential for advisers and their clients.
Interest rates were held at rock bottom levels by several leading developed nations for the best part of a decade as a defence against continuing global economic retrenchment in the wake of the financial crisis. This era of cheap money was accompanied by additional monetary easing methods, in particular, so-called quantitative easing (QE), whereby central banks printed money with the blessing of governments. Most usually this was accomplished by the central bank buying bonds from banks to free up their lending capability. This resulted in a ballooning of central bank balance sheets and created concern that the cash released was finding its way into financial assets, fuelling the long bull market that has yet to end.
The road to nowhere
But just as the long period of near zero interest rates has come to an end in the US and will finish elsewhere too, so QE is running out of road. Withdrawing this source of cheap financing and unwinding the bloated central bank balance sheets will have consequences that are hard to predict accurately, but money will inevitably become tighter. The knock-on effect on interest rates and bond yields is also difficult to forecast, though some comfort may be taken from the likelihood that the direction and speed of travel must be constrained by how economies are coping with these tougher conditions.
Bond funds have been hugely popular
There was quite a flow of investors’ money into bond funds in the wake of the financial crisis. They were viewed as less volatile and, of course, providing superior income returns. Investment styles proliferated, with a variety of approaches being adopted. Some funds achieved the accolade of generating both capital appreciation alongside good income yields but, as with equity funds, they quickly proved a group of sectors that could deliver widely different experiences for the investor.
How such bond funds will hold up in what many would consider a more normal interest rate environment is a moot point. It is worth recalling that a yield gap remains here between what income can be achieved from equities and that which is generated from the government bond market. This is important because for many years it was a reverse yield gap that prevailed in this country.
The yield gap
Until shortly after the Second World War, equities yielded more than gilt-edged securities on average, reflecting the greater degree of risk they carried. It was primarily the move by pension funds in the 1950s to diversify their assets into ordinary shares that created the reverse yield gap. The rationale was simple. Well managed companies could increase their dividends regularly, whereas fixed interest securities were, as the name suggested, providing a fixed rate of return. Moreover, publications, such as the Barclays Equity/Gilt Study which looked back to the end of the 19th century, could demonstrate that over any reasonable period, such as five years, equities would outperform gilts on a total return basis.
In more recent years, these long held theories have taken something of a battering, with bonds benefitting from the dramatic fall in interest rates and equities suffering from more volatile conditions and financial uncertainty. A yield gap has been re-established, though it may yet prove a transient experience for investors. And bonds have outpaced equities over some five year periods.
Might this continue? Somehow I doubt it, though it is a brave investor who says it could never happen. Inflationary pressures are rising in some parts of the world, even if cost of living increases are subdued in others, such as the single currency zone in Europe, as an example. The return to a more normal interest rate environment is unlikely to be swift or even across the globe. Witness the way in which US government yields are rising, while those here and on the Continent are not.
Recent economic data gives support to the belief that interest rates and bond yields are likely to rise slowly, if at all. The first quarter of the current year proved disappointing for both Europe and the UK in terms of the level of growth achieved. Sterling suffered as a less aggressive approach to interest rate management looked in prospect for the Bank of England, while the European Central Bank maintained a steady, loose monetary policy. Of course it could, and probably will, change over time, but for the time being bond holders look like being able to take a sanguine look towards the future.