Tom Stevenson: the ‘dual case’ for government bonds

This article was originally published in The Telegraph.

Not trying to time the market is an article of faith in my business. The conventional wisdom says you can’t do it consistently well so you shouldn’t attempt it. But while it’s impossible to catch the top and bottom of the market, there are moments when the odds are stacked in your favour.

At times like this, you have to answer the question: if not now, then when? And as we reach the top of the interest rate cycle, it feels like - for one investment in particular - we have reached that point.

The market’s response to an uncontroversial comment from the Bank of England’s chief economist Huw Pill suggests investors are looking for reasons to become more optimistic. He said this week that it is not ‘unreasonable’ for the market to expect the first UK interest rate cut next summer. That’s not exactly a promise of easier policy, especially as he added that it was very likely that the outlook would change over the next nine months. But it is what the market wanted to hear.

Coming on the back of last week’s pause by both the Fed and the Bank of England and following last week’s softer than expected US employment report, Pill’s comment implied that higher-for-longer interest rates may be lower-for-shorter than we thought.  Bond yields, which had nudged above 5% on both sides of the Atlantic, have started to head south again. The level of UK interest rates they imply for December next year is now 4.6%, down from 4.75% at the start of the month and 5% three weeks ago.

So, if we are passing peak interest rates, how should we position ourselves for the monetary policy pivot that appears to be looming on the horizon. For once, we are spoilt for choice. A case can be made for cash, bonds and shares. So, what is the argument for each right now?

Cash and close proxies, in the form of high-quality, short-dated bonds, have been the asset of choice for cautious investors this year. More than $1trn has poured into money market funds since January, mainly in the US but over here too.

Rising rates and volatile markets have made the safe returns from cash funds look increasingly attractive, and the short-lived banking crisis in March and April accelerated the trend. The higher-for-longer rate story has made a risk-free 5% return look good enough for many.

It’s been easy this year to make the case for the short-term debt that money market funds favour because the returns on offer from bonds maturing soon have, unusually, been higher than those on longer-dated bonds. This ‘inverted yield curve’ is typical of the later stages of a policy tightening cycle when central banks are still squeezing the economy and investors are worried that they may be overdoing it. With long bonds yielding less than shorter-dated paper there has been no incentive to tie up your money.

That has started to change more recently as investors have started to worry that inflation may be more persistent than we hoped and that governments may be forced to issue more bonds than the market had expected. That combination of factors has pushed longer-dated bond yields higher, offering investors a better income from safe investments like 10-year government bonds than they have seen in many years. Cash has some competition at last.

A further argument for investing in longer-dated bonds is that they are the biggest beneficiary of falls in interest rates. If you think that the cost of borrowing is going to reduce, then the fixed income offered by a 10- or 30-year bond becomes relatively more attractive and the price of the bond tends to rise. The longer the wait to maturity, the greater the sensitivity to changes in base rates.

So, the imminent pivot in monetary policy on either side of the pond offers investors a potential double whammy. They can lock in a higher income than has been possible for at least 15 years and they can also look forward to a capital gain as and when interest rates start to come down in due course. Government bonds are all about the outlook for interest rates. In a country like the US or Britain you know you’ll get your money back.

The case for the bonds issued by companies, but also their shares, is more nuanced as we transition from monetary tightening to easing. On the face of it, lower interest rates are good news for both types of investment because they reduce the cost of borrowing and increase consumption and economic activity.

However, the period immediately after a peak in interest rates can be a tricky time for corporate bonds and shares. Quite reasonably, the market focuses not just on the fact that interest rates are starting to fall but also on the reason why.

Interest rates are cut when central banks are worried about recession. Unlike governments, companies can and do fail to meet their obligations and this needs to be factored in.

So, of the various options for investors at this turning point, the most attractive are government bonds. Cash is safe and offers an attractive yield, but that income will fall as rates come down.

Shares will in due course benefit from falling rates, but they must first navigate the economic slowdown that’s prompted that change of policy. Corporate bonds are caught between the tailwind of falling interest rates and the headwind of rising defaults.

The dual case for government bonds - income and capital gain - is the most compelling right now. If ever there were a moment to dare to time the market, it is now.

For the latest on interest rates, check out this article by Nafeesa Zaman. 

Important information: - investors should note that the views expressed may no longer be current and may have already been acted upon. Please be aware that past performance is not a reliable guide indicator of future returns. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.