Calling the end of the 30-year bond bull market has been a popular pastime for many years now. It has not made anyone rich, though, because demand for the reliable income from Government and corporate bonds has remained high in an environment of persistently low interest rates.
This week, however, the sceptics seemed to gain the upper hand and some of the biggest names in fixed-income investing were warning that bonds may have finally entered a sustained downturn.
Bill Gross, the former Pimco investor who is sometimes dubbed the Bond King, tweeted: ‘Bond bear market confirmed today.’ He said his funds were selling US Treasuries short, betting that they will fall further.
A sell-off of the benchmark US 10-year Treasury bond on Tuesday and Wednesday saw its yield (which moves in the opposite direction to its price) rise to its highest level since the spring at 2.6%. That reflected fears that the US central bank may raise interest rates more quickly this year than expected.
Interest rate expectations have firmed since President Trump’s success, just before Christmas, in pushing tax reform plans through Congress. Tax cuts are expected to release cash into the American economy, triggering more economic growth and higher inflation.
Investor nervousness has increased this week for a couple of other reasons too.
First, data on Tuesday showed that the Bank of Japan has begun to rein in its purchases of long-dated bonds. If it were to continue to cut stimulus in this way it would be following the European Central Bank and Federal Reserve, which have both started to scale back quantitative easing programmes this year.
Second, market speculation on Wednesday focused on China, one of the biggest buyers of US Treasuries, suggesting that Beijing’s enthusiasm for US government debt is cooling. The Chinese authorities subsequently poured cold water on those stories but the seeds of doubt had already been sown.
The bond market has sent investors mixed messages recently. The three interest rate rises by the Federal Reserve in 2017, and the expectation of the same in 2018, have confirmed the US central bank’s desire to normalise monetary policy after many years of rock-bottom interest rates. All other things being equal, that would be bad news for bond prices because it would make their income streams less competitive with cash.
However, many investors have doubted whether the Fed will actually be able to deliver the expected rate rises in the absence of meaningful inflation. The absence of wage inflation, in particular, has puzzled economists and central bankers because historically low unemployment would normally put upward pressure on salaries. So far it has not.
The Trump tax reforms appear to have been the catalyst for a sea-change in inflation expectations. One measure of these (called the ‘break-even’ rate) has climbed above 2% for the first time since March.
Why does this matter?
A reversal of the long bond bull market would be significant for investors because fixed income investments have been a great source of stability in portfolios in recent years.
When the equity market has experienced its periodic dips (notably in 2000-2003 and after the financial crisis), the bond market has continued to perform well, especially during periods of falling interest rates. This has smoothed returns in well-diversified portfolios.
With some market watchers expressing concern about the level of the equity market as we enter 2018, bonds have offered a reassuring source of diversification. Having a balance of bonds and equities has reduced the need to try and time the ups and downs of the stock market.
If bonds do enter a bear market, it will make investors more concerned about avoiding losses in the equity market too.
How to respond?
The first point to make is that the bond market has bounced back from previous wobbles, consistently defying the sceptics over the past 30 years. It was interesting to see strong demand for US Treasuries at an auction of bonds on Wednesday, indicating a still high demand for this most reliable income if the yield is high enough.
It is worth remembering, too, that some of the factors which have driven bond yields to historic lows remain in place. These include high levels of indebtedness around the world and an ageing population increasing savings rates. The recovery in the global economy is by no means guaranteed either.
So, it is too early to give up on bonds. They continue to act as a useful diversifier in a mixed portfolio and they tend to be much less volatile than equities.
Our preference has always been for the most flexible bond funds which allow investors to benefit from a professional’s expertise in allocating money between the different types of bonds (from Government issues, to corporate bonds and inflation-linked debt).
The Select 50 has a few of these go-anywhere funds. We like:
The Fidelity Strategic Bond Fund, managed by industry veteran Ian Spreadbury who aims to combine income and capital preservation with low volatility.
The Jupiter Strategic Bond Fund, managed by Ariel Bezalel, which has a global remit and combines top-down macro views with bottom-up stock-picking.
The M&G Optimal Income Fund, managed by Richard Woolnough. This is the most flexible of all the funds, even having the ability to buy some equities if the manager wishes.
The value of investments and the income from them can go down as well as up, so you may not get back what you invest. When investing in overseas markets, changes in currency exchange rates may affect the value of your investment. Please be aware that the price of bonds is influenced by movements in interest rates, changes in the credit rating of bond issuers, and other factors such as inflation and market dynamics. In general, as interest rates rise the price of a bond will fall. The risk of default is based on the issuer’s ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between different government issuers as well as between different corporate issuers. The Select 50 is not a recommendation to buy or sell a fund. This information does not constitute investment advice and should not be used as the basis for any investment decision nor should it be treated as a recommendation for any investment. Investors should also note that the views expressed may no longer be current and may have already been acted upon by Fidelity. Fidelity Personal Investing does not give personal recommendations. If you are unsure about the suitability of an investment, you should speak to an authorised financial adviser.