Sell-off: The current crisis in UK government bond markets has not been quelled
A sharp sell-off in UK bond markets has left many investors sitting on heavy losses.
Chancellor Kwasi Kwarteng’s mini-Budget last month spooked international bond investors, but increases in interest rates to curb inflation have also played a major role in the crash.
As interest rates start to rise the returns from bonds, known as their yields, have to increase as well to keep luring buyers.
That makes the yields from older existing bonds look less attractive so investors dump them in a hurry, causing bond prices to plunge.
‘Funds investing in bonds have struggled this year as markets adjusted to the higher interest rates that are needed to tame inflation around the globe,’ explains Rob Morgan, chief investment analyst at Charles Stanley.
‘When inflation and interest rates are higher, investors demand a greater return on their assets to compensate for price rises across the economy.
‘That means a higher yields on bonds, and if yields are higher prices must be lower, which explains the falls we have seen.’
Meanwhile, the mini-Budget last month dismayed international investors, due to worries that higher borrowing to fund tax cuts made the UK a riskier destination for their cash.
The current crisis in UK government bond, or gilt, markets has not been quelled, despite the Bank of England stepping in temporarily to protect final salary pension funds.
These are heavily invested in bonds, particularly in long duration gilts, but some became forced sellers due to exposure to risky hedging strategies known as ‘liability-driven investments’.
Below, we look at the fallout for investors in bonds, including those exposed via their pensions.
However, rising yields do make bonds look more attractive, particularly compared with usually riskier stock markets, which have also suffered losses.
So, we also explore where buying opportunities might lie after the bond price collapse.
Bond prices and yields
Governments around the world issue bonds in order to borrow money to help pay their bills.
Investors, including banks, insurers and pension funds as well as individuals, buy them in order to earn a return.
Bond ‘yields’ are a measure of the annual return to investors who buy this debt.
Bond ‘prices’ are the cost, or what these investors pay to buy the debt.
Bond yields and their prices move in opposite directions. When yields move up, prices fall, and vice versa.
Read more about recent moves in UK government bonds, called gilts, here.
What has happened to bond investments?
Bond markets are being buffeted by a combination of high inflation, rising interest rates and politics, according to RBC Brewin Dolphin investment manager Rob Burgeman.
‘UK government bonds – also known as gilts because of their perceived gold-plated status – are traditionally seen as a safe haven in stormy waters.’
Burgeman notes that corporate bond funds have also been affected by fears the ultra-low interest rate environment that persisted since the financial crisis in 2007 will not return, and inflation may also not return to recent low levels.
‘These factors mean that investors need more compensation – in the form of higher interest rates – for the risk of lending money to governments and companies.
‘This has, in turn, led to bond funds giving back almost all of the return that they have made over the last five years.’
Laith Khalaf, head of investment analysis at AJ Bell, says: ‘Bonds are generally held as a safe bit of ballast in a portfolio, but this year they have been anything but, as fund prices have dropped like a stone.
‘The return of inflation and rising interest rates has taken its toll on the attractiveness of the fixed income streams offered by bonds, along with the market getting the jitters about the new Chancellor’s fiscal plans.’
He adds: ‘This bond market reckoning has been a long time coming, as the market has been propped up at irrational levels by loose monetary policy from central banks, and particular the quantitative easing scheme which saw the Bank of England buying up large parts of the bond market.
Rob Morgan: Increase in global bond yields was accentuated in the UK assets as markets were unnerved by the Chancellor’s ‘mini Budget’
‘Nonetheless it’s been a painfully sharp period of adjustment for bond investors, and there may be even more to come.’
Morgan says financial markets are currently going through their most painful period since the global financial crisis, back in 2007-2008.
‘The increase in global bond yields was accentuated in the UK assets as markets were unnerved by the Chancellor’s ‘mini Budget’.
‘Mr Kwarteng announced large tax cuts aimed at jump-starting growth and energy subsidies funded from borrowing, which was pro-business, but they were not accompanied by the independent fiscal and economic projections a full Budget would entail.
‘So this left investors to draw their own conclusions about how measures might fuel inflation and government borrowing.’
Morgan says bond funds have therefore faced a huge headwind, with government debt usually regarded as ‘safe’ taking some of the hardest hits.
Bond investments see sharp declines
Source: FE and AJ Bell
What about pension investors who are moved into bonds as they approach retirement?
During the current bond market turmoil, much attention has been paid to the Bank of England’s high profile intervention to shore up final salary pension schemes.
However, savers into such schemes receive guaranteed pensions, and individually bear none of the investment risk. Even if the worst happens and their scheme goes bust, their pensions will be rescued by the Pension Protection Fund.
The pension savers most exposed to the current turbulence are those in workplace defined contribution schemes, because they shoulder all the investment risk themselves when building their retirement pot.
What are defined contribution and final salary pensions?
Defined contribution pensions take contributions from both employer and employee and invest them to provide a pot of money at retirement.
Unless you work in the public sector, they have now mostly replaced more generous gold-plated defined benefit – or final salary – pensions, which provide a guaranteed income after retirement until you die.
Defined contribution pensions are stingier and savers bear the investment risk, rather than employers.
However, the vast majority stick with their employer’s ‘default’ fund which is invested in equities – considered higher risk, but higher reward investments over the long term – rather than bonds through most of their working life.
But, crucially, in the run-up to retirement savers in these schemes are often gradually shifted into bonds, which have historically been regarded as the ‘safer’ option, a process known as ‘lifestyling’, or ‘de-risking’.
The idea is to protect savers against sudden sharp losses when they are just about to start tapping their pensions, by buying an annuity that generates a guaranteed income, or more commonly these days via an invest-and-drawdown scheme.
That assumption bonds are safer has clearly gone awry in the present crisis, and people approaching or on the brink of retirement might therefore be facing unexpectedly big losses, especially if their scheme uses annuity hedging funds.
Laith Khalaf of AJ Bell says the average annuity-hedging fund is down 45 per cent so far in 2022, and 18 per cent since the Government’s mini-Budget on 23 September.
‘These funds are typically provided by insurance companies and invest in long-dated bonds to hedge investors against movements in annuity rates,’ he says.
‘Even after this year’s steep price falls, they still account for £9billion of pension savers’ money.
‘Annuity rates have indeed shot up this year, as some recompense for pension savers opting for an annuity at retirement.
‘But since the pension freedoms were introduced in 2015, only about one in ten pension savers now buys an annuity, with the remainder keeping their pension fund invested or simply drawing it all out in cash.
‘Many investors will therefore now simply be sitting on much smaller pensions than they were at the beginning of the year, as a result of the bond market sell-off. And the rise in annuity rates will be cold comfort to those who have no intention of buying an annuity.’
Laith Khalaf: The rise in annuity rates will be cold comfort to those who have no intention of buying an annuity
Khalaf says pension savers are shifted into these funds near retirement, so have little or no time to rebuild their savings after sustaining losses, and many probably won’t be aware the switch is happening.
But he adds that investors in ‘lifestyling strategies’ are unlikely to have felt the full force of bond losses, because they are shifted into them gradually and there is usually a cash element too.
And some more modern defined contribution schemes do some de-risking of savers’ default funds ahead of retirement, but might keep a large stake still in stocks, because many people now stay invested in old age.
What should you do if you hold bonds, and are there buying opportunities?
‘As with equity funds, it is vital to be forensic about what you hold and try not to be too sentimental about historic holdings,’ says Burgeman.
‘After these falls, bonds are likely to prove to be more defensive in difficult markets, so are certainly worthy of consideration for those looking to provide some ballast” to their portfolios to reduce some of the up and down volatility of purely equity-based savings.’
Morgan says there are signs inflation is slowing which means less aggressive interest rate rises will be required.
‘While there could be further volatility in the short term, bonds are looking more attractive than they have done for more than a decade, certainly if inflation is going to moderate.’
If you are a pension saver, Khalaf says if you plan to keep your pot invested and live on the income in old age, you don’t need to make a wholesale switch from equities into bonds as you approach retirement age, as is the conventional wisdom.
‘If you’re going to stay invested for 20 or 30 years, you should have a healthy slug of equities in your portfolio.
‘However after the bond sell-off we have seen this year, it is now at least possible to get a reasonable income stream from bonds, so for those retirees looking for income from their portfolio, bonds might be worth considering as an inclusion alongside equities.’
Rob Burgeman: Bond markets are being buffeted by a combination of high inflation, rising interest rates and politics
Which bond funds are tipped by our experts?
‘To my mind, there are three types of fund that are going to be worth considering in this environment,’ says Rob Burgeman of Brewin Dolphin.
‘Firstly, look at the lowest risk bond funds around.
‘The iShares UK Gilts 0-5 Years ETF (ongoing charge: 0.07 per cent; yield 0.30 per cent) invests in very short-dated government bonds which are currently offering returns of between 3.5 per cent and 4.5 per cent.
‘The short-dated nature of this fund means it has proved much more resilient over the last year – it is down by 6.8 per cent this year – and should be relatively defensive if interest rates continue to rise over the year ahead to combat inflation.’
He highlights a second type of fund worth considering as ‘strategic bonds’, and flags Jupiter Strategic Bond (ongoing charge: 0.73 per cent; yield 4.40 per cent).
‘The manager has an ability to trade between the different types of bonds that are available, switching between government bonds, corporate bonds and emerging market bonds and, at the same time, trying to optimise the average age and quality of the portfolio.
‘This fund, run by Ariel Bezalel has produced a return of -17.0% this year which is slightly better than the broader sector and the managers experience should enable him to participate in any recovery in the sector.’
Burgeman also suggests investors take a look at short-dated high yield bond funds, exemplified by AXA US Short Duration High Yield Bond (ongoing charge: 0.46 per cent; yield 4.20 per cent).
‘While the underlying bond type – high yield US bonds – is adventurous, the short-dated nature of these funds mean that the fund is relatively insulated from shorter term movements in interest rates,’ he says.
‘The fund has produced a return of -6.60 per cent this year, but should be poised to benefit from US interest rates peaking in the months ahead.’
Source: RBC Brewin Dolphin
Rob Morgan of Charles Stanley says a truly active manager that invests across the bond spectrum from government bonds to riskier high yield debt could be a good option for investors.
He tips Janus Henderson Strategic Bond (ongoing charge: 0.70 per cent; yield 2.20 per cent), saying: ‘Managers John Pattullo and Jenna Barnard aim to add value by taking strategic asset allocation decisions between countries, asset classes, sectors and credit ratings.
‘The fund has recently been significantly invested in longer dated, high quality and more interest sensitive bonds, which has been challenging.
‘While the managers may have been too early in their call, this fund would benefit from global inflation subsiding faster than widely anticipated.’
Morgan also suggests investors take a look at Rathbone Ethical Bond (ongoing charge: 0.66 per cent; yield 4.60 per cent).
‘At a yield of 7 per cent this is typical of the substantial level of income available on corporate bonds presently.
‘It is an option particularly worth looking at for investors wanting an ethical approach of screening out unacceptable business practices and lending money to companies that have a positive impact on society.’
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