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We’re all painfully aware that the increases in big central banks’ main interest (or policy) rates are driving up borrowing costs. Just this week, the interest rate payable on a five-year mortgage deal jumped above 6%. It was below 1.6% before the Bank of England (BoE) kicked off its current rate-hiking cycle at the end of December 2021.
Ever since central banks began hiking in a bid to cool inflation, the rates of interest (yields) that bond investors earn for lending to governments and companies have soared. Because bond coupon payments are fixed, their prices must fall for their yields to be in line with higher market interest rates (bond income/price paid). This means yields run in the opposite direction to bond prices. More recently, the yields of short-dated bonds have been rising (and their prices falling) a lot more than longer ones. This reflects investors’ growing realisation that, as high inflation hangs around, policy rates will go up more than they’d initially expected, which will keep eating away at the value of the fixed interest payments (coupons) that bonds pay out.
The yield curves that plot the differences in yields that investors demand in compensation for lending their money over various periods usually slope up. Investors usually expect to earn more interest by lending for longer. But there are times when yield curves are flat and others when they turn completely on their head.
Yields at all the various debt maturity dates change constantly, and often by different amounts. Sometimes those at the front of curves may rise as those further along fall. That’s because shorter-term yields are driven by investors’ more immediate expectations on where central banks’ main interest rates are heading, while longer ones represent reflect their views on the outlooks for rates, inflation and economic growth in the medium to long term.
The UK yield curve is upside down
More recent outsized moves in yields at the front of curves mean they’ve shot way above those for longer-term ones, which is to say that yield curves have ‘inverted’ sharply. Inverted yield curves are seen as a huge warning sign that a recession is on the way. They show that while investors expect interest rates to rise near term, they believe that these higher rates will eventually slow GDP growth so much that the economy will start to shrink in the medium term, leading central banks to reverse course and start cutting them again.
Over the last month or so, the already extreme inversion of the UK yield curve has started to get truly eye-watering. At the time of writing, two-year UK government bonds (gilts) were yielding around 1% more than their 10-year counterparts. The surge in short-term yields is being driven by inflation that’s higher here than elsewhere and also falling less quickly. Even though it’s already hiked rates more times than any other central bank, the BoE has had to acknowledge recently that it will take “a lot longer” than it had expected for UK inflation to drop meaningfully. That has sent investors scrambling to price in quite a few more BoE rate hikes this year, driving a stratospheric rise in two-year gilt yields. They rose from 4.3% to 5.3% in June alone.
For quite a while, we’ve been positioned for more BoE rate rises for longer and underweighting the interest rate risk (duration) in our funds. Longer-dated bonds are particularly sensitive to rate changes and their prices usually drop the most when rates are rising. That’s because their interest payments are fixed for longer, so having a locked-in less-than-market interest rate will hurt more than if it was for only one or two years. Of course, the opposite is also true: if rates start falling, longer-term bond values can rise rapidly.
Because short-dated bonds pay fewer coupons, the returns they deliver stem mainly from whether their prices go up or down before they mature. The massive sell-off in short-dated debt means some corporate bonds issued about three to five years ago have been trading at bargain prices, way below their par value (their face value when they were issued and what is returned to investors when the bonds mature). Snapping them up at very cheap prices can offer scope to make decent capital gains when they mature.
While being underweight duration worked well us for last year, and so far this year too, it’s critical not to be too short-sighted. Taking a longer-term perspective, it feels like the things that drove us to underweight duration (rising interest rates and high inflation) may start to exert less influence soon. The BoE may be adamant that it’ll keep on hiking until inflation budges, but many more of its hikes lie behind us than ahead.
As yields on two-gilt yields raced higher in June, those on 30-year gilts shifted in the opposite direction and fell slightly from 4.5% to 4.4%. This drop reflects increasing investor nervousness about how the UK economy will hold up further into the future. By the time BoE rates have peaked, we might be in a full-blown recession and rates could be heading quite a bit lower than they are today.
Longer dated bond yields are likely to at least stabilise and may even fall quite significantly at this point. Long-dated government bonds tend to perform particularly well soon after the last rate hike in a tightening cycle, as economic growth slows, inflation drops and investors price in lower rates in coming years. When this happens, it can be risky to be underweight duration.
Building a barbell
Of course, lots of things are still very uncertain right now and there are risks involved both in being too near-sighted and in looking too far into the future.
So while we’re adding more duration to our funds, we’ve also been building what’s known as a ‘barbell’ structure. In bond investing, a barbell combines significant weightings of short-dated bonds with significant weightings of much longer-dated ones.
One end of our barbell tilts towards short-dated corporate bonds, allowing us to take advantage of some exceptionally high yields (and cheap prices). The other is tilted towards much longer-duration gilts. In a slowing-growth, falling-rate environment, it’s duration that usually outperforms so we think this tilt could give us a nice cushion against any volatility at the short end as the UK yield curve starts to get back to a more normal shape.
