Investment Comment
6th October 2023
Cash is king or is bond, long bond, back?
61 years after the release of the first James Bond film “Dr. No” on 5th October, it is perhaps timely to be talking about bonds. The rise in yields and losses in the bond market has shaken and probably stirred investors. Certainly, with interest rates and bond yields returning to levels unseen in many years, investors are faced with a different set of choices for the next decade than for the last.
Over recent months despite economic growth waning in the US and inflation falling, and very slow if not recessionary conditions in the UK and Europe, bond yields have moved higher, which is rattling investors both in fixed income but also in other asset markets. Even the US equity market fell 5% in September as bond yields moved higher.
Journey to now
The bond market initially rallied at the end of 2022 as investors saw a slowing US economy and investors priced in interest rate cuts at some point in 2023. Despite interest rates rising by more than expected, the US economy has remained more resilient than economists had forecast and interest rates have continued to climb higher.
US inflation peaked at the end of 2022 and has evolved in line with expectations, yet despite inflation falling quite significantly from 9% in mid-2022 to below 4% in June 2023, bond yields have continued to rise. Despite moving higher in recent weeks 10 year bond yields are still at a lower level than short-term interest rates. So unusually investors are offered the opportunity of receiving higher returns on very short-dated bonds when compared to longer dated bonds. We will return to this temptation below.
Despite lower inflation over the past year bond yields have continued to climb, which is historically unusual.
Source: Artorius, Bloomberg
Inflation linked bond yields have risen in parallel with conventional bond yields, suggesting that investors are not discounting a higher inflationary backdrop.
Source: Artorius, Bloomberg
The post 2008 regime of ultra-low interest rates looks to have changed. Economists have consistently underestimated the rise of interest rates and bond yields over recent years, and so, investors are rightly wary of further moves higher.
To a casual observer, inflation would seem to be the cause for the recent spike in bond yields, as it was in 2022. We suggest otherwise, and so does the bond market. One can derive the inflation expectations by looking at the difference between yields in conventional and index (inflation)-linked bonds, both here in the UK and in the US. The difference between the two is breakeven inflation. If fears over inflation had been the driver of higher bond yields, then one would have expected breakeven inflation to rise and so conventional yields would increase by more than the equivalent index-linked bond yield. Both in the UK and the US, the yield difference between the two types of bonds has remained relatively stable, suggesting that the market is not expecting higher inflation. Inflation doesn’t appear to be a long-term problem in the eyes (or pockets) of investors.
Cash or bonds?
So, what now? As stated above, investors can lock-in a higher return on cash, Treasury bills and other short-term products than on longer term bonds. Too tempting? Too good to be true? In the US, 3 month Treasury bills offer 5.5%, 2 year Treasury bonds yield 5%, whilst 10 year bonds yield 4.7%. Naturally there are some investors who are tempted by the higher headline yields on offer from short-dated Treasury bills and bonds. The same pattern of higher yields on offer from shorter-dated bonds is also the case in the UK.
However, this ignores the potential return that may be generated as yields move. There is an inverse relationship between bond yields and prices, so as yields fall, prices rise. If, as we suspect, that interest rates and bond yields are close to a peak, then it is possible that the bond market may produce opportunities, but the timing of this is key. If 2- and 10-year yields fall by 0.5% by the end of the year then holding 10 year bonds would deliver a 20% return as the price of the bond will rise (on an annualised basis) compared to a 7% return from 2 year bonds and 5.5% from 3 month Treasury bills. The reason for this is the impact of duration. Longer dated bonds have a higher duration, which means that there is a larger price move for the same percentage point yield change.
Wait for interest rates to peak?
We have looked back at the history of returns for cash and bonds through the economic cycles. Compared to cash, bonds of all types tend to do much better when interest rates have reached their peak. In the US, after interest rates stop increasing (not necessarily cut) government bonds have subsequently delivered, on average, a 36% return over the subsequent 3 years compared to cash returns of 15%.
In the UK, government bonds have historically delivered a 20% return compared to sub 10% returns for cash in the first 3 years after the last interest rate hike. We note that the returns of UK corporate bonds lag government bonds initially, suggesting to us that even though interest rates stop going up, investors begin to price in higher credit risks around company borrowing and so opt for the safety first option of government bonds.
Cumulative returns of government, investment grade corporate bonds and cash
Once interest rates stop increasing, holding bonds rather than cash has been a better investment over the subsequent few years with ‘safety-first’ government bonds performing best initially, both in the US and UK.
Source: Artorius, Bloomberg
Source: Artorius, Bloomberg
It’s important to note that historically when the bond market experiences a sharp sell-off, similar to what we’ve seen of late, a financial event tends to occur in over-leveraged parts of the global economy. This is where excessive debt is previously accumulated when credit is cheap and freely available, as was witnessed in the global financial crisis in 2008 and the Euro-debt crisis in 2009. Whilst these crises are difficult to predict, the current sell-off in the bond market will be creating stress in parts of the economy of which could ultimately become a recession catalyst.
For investors, it may feel appropriate to hold cash during economic uncertainty however, if a US recession becomes a reality, or if the current bond market weakness creates further financial distress, then the Federal Reserve will be forced to hold interest rates steady or cut them. In this scenario holding longer duration bonds brings an opportunity of attractive returns.
All expressions of opinion reflect the judgment of Artorius at 6th October 2023 and are subject to change, without notice. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete; we do not accept any liability for any errors or omissions, nor for any actions taken based on its content. The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested. Past performance is not a reliable indicator of future results. Nothing in this document is intended to be, or should be construed as, regulated advice. Artorius provides this document in good faith and for information purposes only. Reliance should not be placed on the information contained within this document when taking individual investments or strategic decisions. Artorius Wealth Management Limited is authorised and regulated by the Financial Conduct Authority. Artorius is a trading name of Artorius Wealth Management Limited.
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