Investment management consultant MATTHEW FEARGRIEVE explains the market dynamics pushing bond yields higher, and suggests some protective measures for your investment portfolio.
At its meeting on 17 March, the Federal Open Market Committee (FOMC) confirmed that interest rates in the US would remain at zero. There was no surprise here; it was widely anticipated that the Fed would remain committed to its policy of supporting the US economy until it is back on its feet. As if to underscore this, the Fed indicated that it isn’t expecting a rate increase until 2023 at the earliest, and reiterated that the bar for raising the rate will remain high.
Whilst intimating that its inflation expectations remain anchored, the Fed nonetheless scaled up its inflation forecast for 2021, which it now sees as running to 2.4%, ahead of its previous estimate of 1.8%.
The Fed also remained committed to the pace it has set for bond buying. It will continue purchasing at least US$120 billion of US Treasury bonds and mortgage-backed securities each month. The yield on the 10-year Treasury note fell on this news.
So: low interest rates, rising inflation forecasts and government bond repurchases, on top of huge, post-pandemic government spending programmes: this is the (entirely natural) backdrop to the recent inexorable rise in yields on government bonds.
Why are yields on government bonds rising?
Yields on government-issued debt instruments are rising because of two things inflation and fiscal stimulus. These two dynamics normally cause price inflation.
Inflation is bad for government bonds. When prices rise at a rate greater than the interest earned on a bond, it follows that the value of the fixed income delivered by the bond will fall. Consider a five-year bond paying 2% nominal interest. If inflation rises to 2.5% for those five years, the income paid by the bond will not be able to keep up.
Fiscal stimulus is also bad for government bonds. When governments pump out debt, the price of bonds falls, whereas the yield, being inversely related to bond prices, rises. A related market phenomenon is the recent emergence of bond vigilantes, bond investors who discourage fiscal stimulus by selling bonds in large amounts, thereby increasing bond yields. This in turn makes borrowing more expensive for governments, which acts as a potential disincentive on issuing more debt, which is the desired goal of the vigilantes.
Rising yields in turn depress bond prices, making investment in bonds and government debt less attractive. The combined market forces of inflation and rising yields have caused the market value of bonds to fall, as have the activities of the bond vigilantes.
The rising yields will stick around for as long as inflation is a worry. And an inflationary economic environment favours certain kinds of asset classes.
What do rising bond yields mean for my portfolio?
When thinking about rising bond yields and the prospect of inflation, it is necessary as usual to consider separately the “bonds” (debt) and the “equities” (stocks and shares) components of your portfolio.
Given the uncertainties in the bond markets, you would be forgiven for thinking about moving some of your bond and fixed-income investments into cash, whilst waiting to see where longer-term bond rates end up.
Whilst uncertainties in the bond (and equity) markets might argue in favour of increasing your cash reserve to between 10% to 17% of the overall value of your portfolio, you can are by no means precluded from buying bond funds for your portfolio. Just make sure that you follow these two, protective rules.
First, avoid bonds with longer maturities, say, anything over three to five years. Bonds with longer maturities are more exposed to changes in interest rates, meaning they have more to lose if rates rise (which they invariably do, once inflation kicks in).
Secondly: use inflation-linked bonds (like TIPS) as a way of keeping your money in fixed income whilst protecting against inflation risks. The coupon offered on these bonds is linked to a rate of inflation, meaning the interest they pay rises as inflation goes up.
What follows are some low cost, exchange traded funds (ETFs) and mutual funds that provide (a) index-linked exposure to government debt and (b) equities in the asset classes just discussed, both in return for an acceptably-low annual charge.
Please remember, these are ideas only, not recommendations or formal investment advice.
The iShares USD TIPS 0–5 UCITS ETF (GBP Hedged) combines both protections, by investing in index-linked US Treasury Bonds with short maturities (0–5 years). With a respectable performance history, a low buy price (around £5 per unit at time of writing) and an annual charge of 0.12%, this product allows you to include bonds in your portfolio and hedge against possible losses due to inflation.
A suitable bedfellow for this fund could be the Lyxor Core UK Government Inflation Linked Bond UCITS ETF, providing access to UK government bonds with in-built protection against inflation, for an OCF of just 0.07% (upside) and a rather high per-unit buy price of around £20 (downside).
Finally, a fund providing access to global government bonds with index-linked protection against inflationary pressure: the iShares Global Inflation Linked Government Bond UCITS ETF, a fund with a Morningstar rating of Four Stars, and an OCF of just 0.20%.
Market fears about inflation are already being played out on the US Nasdaq index, which is dominated by high growth tech stocks. The index has fallen by more than 8% in the past two weeks.
Inflation, though, is not necessarily a bad thing for all stocks. Indeed, it has different implications for different types equities. A big consequence of inflation (or the fear thereof) is to drive in the realm of investor sentiment a rotation out of (high-value) growth stocks into (cheaper and more cyclical) value stocks.
Growth stocks were the big winners of 2020: the tech, pharma and stay-at-home retail stocks, which did so well partly because of the low rate, low inflation environment. An inflationary environment threatens that appeal.
And so US mutual funds focused on value stocks enjoyed inflows of US$6.3bn in February, up from US$1.3bn in January. Growth funds, in contrast, saw outflows of US$18bn in January.
Correspondingly, the MSCI global value index has risen nearly 9% so far this year. In 2020r it fell by 3.6%, lagging the MSCI global growth index by 33% as money poured into stocks like Tesla, Peloton and Apple. So far in 2021, in contrast, it is the likes of ExxonMobil, Caterpillar and Wells Fargo that are doing better.
Gold, property, commodities, infrastructure and smaller companies are sectors that are set to do better than they did over the pandemic. The kinds of stocks which have benefited so much from the a low-rate, low-inflation environment that we have had for some time — the prime example being Big Tech- are now expected to perform less well than they did in 2020.
Sectors like materials, commodities, consumer goods and industrials are all expected to start to do better as global economies start to pick up speed.
Commodities historically outperform when inflation kicks in. Their relationship is not clear cut though. Rising commodity prices tend to be both a cause and a reflection of inflation. Commodity producers often raise their prices in line with inflation because their cost of production goes up, in turn exacerbating those rises.
Separately, asset classes like property and infrastructure often do well in times of inflation. Infrastructure assets have explicit linkage to inflation, and the relationship of infrastructure to property is instructive: as prices rise, so do building costs, and therefore, so do property prices.
Lastly, many investors will have their eye on gold. Many of us will have bought some exposure to gold miners and gold producers for our portfolios at the start of the pandemic, given that gold is the traditional flight-to-safety asset when equity markets are turbulent. When inflation is driven by rising commodity prices, gold tends to do well.
The Lazard Commodities fund tracks the Bloomberg Commodity Total Return Index, with most of its exposure to blue chip gold, gas and agricultural producers and processers in the US and the UK. The fund is structured as a Dublin OEIC and this entails higher fees: an annual charge of 0.50% together with a per-transaction cost of 0.48%, which will be a turn-off for some investors.
Infrastructure & Property
The Legg Mason Clearbridge Global Infrastructure Income fund is rated with Five Stars by Morningstar but we feel its five-year performance doesn’t justify its 0.92 annual charge plus whopping 0.62 per-transaction cost.
A cheaper alternative to give your portfolio indirect exposure to international property, and with respectable five year performance, is BlackRock’s iShares Global Property Securities Equity Index Fund, rated with three Stars by Morningstar and priced at an attractive 0.18% per year with an additional 0.08% per-transaction fee. The fund is an ETF that tracks the FTSE EPRA Nareit Custom Developed Index, which provides you with proxy access to global property companies, just over the majority of which are in the US, with the remainder being fairly evenly split across Canada, Europe (including the UK), MENA, Asia Pacific (including Japan) and Australia.
We explored the fortunes of gold prices over 2020, and their unlikely “safe haven” pairing with Bitcoin in our earlier blog here.
Ninety One Global Gold 1 Acc is a globally invested OEIC owning shares of companies involved in gold mining and in related derivatives, is another holding, and is up 37% over 12 months.
A well-performing catch-all for gold and precious metals with Golden Prospect Precious Metals, which has an underlying investment split of 66% gold, and 25% silver, where producers are 64% and developers 24%.
A higher-costing but still decent alternative with reasonable performance is the WisdomTree Physical Gold ETF, which has an annual charge of 0.39%.
Opinion is divided on the attractiveness of emerging markets. A more positive view is that emerging market economies are a good indirect bet as they benefit from the positive pulse of increased spending by the US consumer.
A regional, emerging market fund with a nice infusion of sustainability is the Stewart Investors Asia Pacific Leaders Sustainability Fund, which allocates the majority positions in the Emerging Asia sector.
An alternative providing broad indirect access to emerging markets is the Artemis Global Emerging Markets fund. Like the Stewart fund, this has the majority of its exposure to the Emerging Asia zone, but has additionally positions in Africa, Latin America and Emerging Europe.
For investors cautious about the prospects for recovery and for rising inflation, and wanting the convenience of a blended fund, the AJ Bell Personal Assets Trust offers a suitably cautious approach with some inbuilt inflation-proofing: it layers a 12% exposure to gold and a 35% allocation to index-linked bonds over a core 40% exposure to high-quality equities like Microsoft, Diageo and Unilever.
The convenience of having a one-stop-shop fund like this comes at a price however: a relatively stiff OCF of 0.86% per annum, but still not bad for coming in at under 1.00% per year.
To learn more about bonds and bond yields, click here.
To find out more about mutual funds and ETFs that could protect your portfolio from inflation, click here.
For some Ideas for your ISA in a post-pandemic recovery phase (reflationary or inflationary) click here for our blog on how to make the most of your 2020/21 tax allowances before the end of the tax year on 5 April.
For our 2021 Investment Outlook across all the major asset classes, click here.
IMPORTANT: the views expressed in this article are opinion only, and are not intended to be relied upon as financial advice or treated as a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.