I’d wager that one of the media’s most used words recently is ‘unprecedented’. Indeed, there have been events that fit the definition – ‘a situation that has never happened, been done or been known before’ – rather well. However, the term is often misused.
Since the beginning of 2022, the ability to legitimately use the term ‘unprecedented’ has increased exponentially. Be it the response to Russia’s invasion of Ukraine, the brief but extreme heat wave, or a British Prime Minister that managed only 49 days in office. These events have contributed to a situation in which UK fixed income investors now face unprecedented, negative returns.
What are fixed income investments?
Fixed income investments appear simple but can be confusing to understand.
Essentially, an investor buying a traditional bond is lending money, be it to a government or firm. In return for the investor lending money, they are rewarded with a fixed number of ‘coupons’ or interest payments, together with a repayment of the initial loan amount, when the life of the bond comes to an end.
For example, suppose an investor purchases a brand-new bond for £1,000, which pays a 5% semi-annual coupon for 10 years. Assuming the £1,000 price paid is the ‘face value’ (the amount the borrower will repay the lender after 10 years), the investor will receive £25 twice a year for 10 years and then, when the bond matures, the investor would receive the initial £1,000 back.
With fixed income, there are a number of risks. The most important are:
Interest rate risk
If an investor wants to buy and sell existing bonds in the secondary market, this is where confusion can arise. Why? Because the ‘value’ of the bond changes due to supply and demand.
Let’s assume interest rates are rising. If an investor holds a 10-year bond paying 5% but new 10-year bonds are paying 8%, the demand for the former bond will fall, and its price will drop below its face value. The reverse is true if interest rates were to fall below 5%. The impact of changing interest rates on bond prices is called interest rate risk.
A related concept of importance to bond investors is duration. Duration rolls up several bond characteristics (maturity date, coupon payments, and so on) into one number and gives a good indication of the sensitivity of a bond’s price to changes in interest rates. The higher the bond’s duration the more its price will change when interest rates move, and therefore the higher the interest rate risk.
It’s also important to understand the inverse relationship between bond prices and yields. When the price of bonds falls, yields increase. And when bond prices increase, yields decrease. Why? Consider our example above. If the bond price increases to £1,500 but the coupon payments remained at £50, the yield is now 3.3% – if the bond price falls to £500, the yield is now 10%.
Credit risk
A high credit rating suggests investors are more likely to receive promised coupons and principal payments on time and in full compared to a lower rated bond.
Credit ratings are assigned to individual bonds, so, for example, the same firm may issue high and low credit rated bonds, with more risky bonds compensating the investor for this higher risk with larger coupons. Investment grade bonds are deemed safer than junk bonds.
Inflation risk
Because the coupon of a bond is fixed, if inflation increases to levels above those forecasted, bond investors are negatively affected, as the buying power of the coupon payments decreases in real terms. Inflation linked bonds are structured to protect investors as when inflation rises, coupons also rise.
Reinvestment risk
If interest rates are falling, investors may have to reinvest any coupon or principal repayments at the lower, current prevailing, interest rate.
Liquidity risk
This risk is not unique to fixed income and arises when investors are forced to sell an asset at a significant discount to market price, in order to quickly sell down a position.
Why do we hold bonds?
Compared to equity investments, fixed income investments are deemed to expose the investor to lower risk. Why? Because future cashflows from bonds, which are used to value assets, in the form of coupon and principal repayments are known with more certainty than dividends.
In the case of bankruptcy, bondholders have a higher priority of claims on any remaining assets compared to shareholders. Lower risk, however, does not mean risk-free. Investors only receive a return because there is risk.
Historically, combining equity and fixed income investments has reduced the overall return volatility of the portfolio. This is because of the lack of correlation between the two asset classes. When equities fall in value, fixed income investments tend to rise, reducing the total fall in value of the portfolio. A recent example of this technique to manage portfolio volatility is demonstrated by the performance of the global bond and global equity market during 2020.
As the following chart shows, equity markets crashed as the world went into lockdown, leading investors to turn to bonds for increased security, meaning bond values rose. A multi-asset portfolio, therefore, offset equity losses with fixed income gains through March 2020.
The worst year ever?
Both equity and bond markets have struggled during 2022. By the end of the third quarter, developed ex-UK stocks were down -9.8%, while UK stocks were down -6.6%. This is obviously of concern to investors, but such figures are not unusual.
We saw above, that as recently as 2020, investors saw large drops in equity markets. In fact, on March 16, 2020, the Dow Jones fell 3,000 points, the largest single-day drop in US stock market history. What is far more unusual today, is the accompanying drop in fixed income, -12.8% in global bonds and -25.3% in UK bonds. Of particular note is the -12.9% fall in UK bonds in the 3rd quarter, compared to a -3.8% drop in global bonds.
Somewhat of the shock for bond investors to declining prices has been the rarity of such events, compared to equity markets. Reviewing the US bond and equity market since 1928, negative returns in equity markets are far more frequent and of greater magnitude than those in US Corporate and US Treasury Bonds.
While it’s clear that negative returns in bond markets are not unprecedented, the magnitudes of the decreases certainly appear to be, particularly for UK investors.
The main culprit
Increasing interest rates, the Central Banks’ response to surging inflation, has been the key driver of falling bond prices. As discussed earlier, there is an inverse relationship between bond prices and interest rates. As interest rates continue to increase with expectations of more to follow, bond prices have fallen globally.
Hedge no more
UK bond investors have suffered more than most, as the pound has steadily fallen against other major currencies over the last year, particularly the US dollar.
How does this impact bond returns? Well, the UK bond market represents a small portion of the global fixed income market. It’s risky to invest only in one market so, to diversify away risk, investors will often invest in foreign bonds. However, this exposes the investor to currency volatility, which can nullify any diversification benefits.
The solution? Use contracts that ‘lock in’ an exchange rate, thus removing risk of currency movements. But now the investors’ return on their foreign bonds includes the return from ‘hedging’. The impact of hedging can be either positive or negative on overall return in any given period. In the case of the UK, the falling value of the pound over recent months has acted to negatively impact returns on foreign bonds.
Given the negative impact of hedging on bond returns, should investors stop hedging? Simply, no. While it is clear that UK bond investors have suffered additional losses because of hedging in the short term, research has shown that hedging remains important in the long term, to reduce the volatility of returns that would be caused by currency fluctuations. After all, we own bonds to reduce volatility in a multi-asset portfolio.
In Liz we…didn’t Truss
The UK’s brief foray into Trusseconomics, served to put additional pressure on the UK bond market.
Following the mini-budget on 26th September, which announced a raft of unfunded tax cuts, equivalent to £45bn a year, together with energy subsides that were estimated to cost £60bn over the next six months, investors worried about the UK’s ability to service its debts. With more risk came the demand for more return in the form of higher interest rates on government debt, as interest rates increased, bond prices again fell.
In addition, markets were concerned the increase in government spending would result in further inflationary pressure and expected the Bank of England (BoE) would respond by increasing interest rates.
Finally, declining asset prices gave rise to most defined benefit pension funds being faced with the threat of significant margin calls, due to a modern “hedging” strategy called Liability- Driven Investing (LDI). LDI is basically an investment strategy that involves a lot of leverage to circumvent the stress on funding ratios that resulted from artificially low interest rates.
To raise money for these margin calls, pension funds were forced to sell gilts (amongst other assets), further decreasing their value. This led to devaluing their posted collateral even more and almost creating a spiral where they had to sell more and more assets to cover further margin calls. This is where the BoE had to step in to “prevent an unwarranted tightening of financing conditions.”
What shouldn’t I do and why?
If something is painful, our natural response is to try and stop it. The same can be said for when we see financial markets fall.
Undoubtedly, some might argue that the best course of action would be to get out and cut your losses and perhaps hold the money in cash until things get better. We disagree. Firstly, selling down the bond position after a loss, crystalises the loss, locking it in.
Secondly, if you sell out now, you will be re-entering the market when prices are higher, effectively selling low, and buying high. Thirdly, if you intend to hold the proceeds of sales in cash, the real purchasing power of that money will be eroded by inflation.
For the majority of investors, bonds are still a smart choice. While 2022 has been an outlier in terms of bond performance, the characteristics of bonds, their lower risk and volatility and solid long-term returns means that an allocation to them in a multi-asset portfolio is still merited.
Final thoughts
Unfortunately, 2022 has been a perfect storm in terms of geopolitical and economic events that have acted together, resulting in high levels of inflation.
The response from policymakers has seen increases in interest rates and the promise of more to come. And, as we know, increasing interest rates result in falling bond prices. UK bond investors, in particular, have suffered disproportionality due to a weakening pound and poor economic management by the government.
This has led some investors to question the rationale for maintaining a bond allocation in their portfolio. While bonds have historically been less volatile than stocks over the long term, we have been painfully reminded that there is no such thing as a free lunch and they are not risk free.
Although 2022 has seen unprecedented losses for UK bond investors, we need to maintain perspective. This can be hard, given the events over the last year, and indeed the last five years.
It seems that UK investors never get a break. Whether its political turmoil following the European referendum of 2016, a global pandemic in 2020 and now, in 2022, a war in Europe. All have challenged investors’ resolve, but only in 2022 have bond markets reacted in such an abnormal way.
As with drops in equity markets, the best advice for bond investors is to stay the course. Selling down positions in the hope of reducing further losses and holding the proceeds as cash – or employing other strategies such as market timing and active management – is unlikely to provide long term benefit.
Maintaining a long-term view is key, as we know from historical data, although both equity and bonds markets may fall in the short term, over the long term, they provide the best possible vehicle for securing investors’ financial goals.
If you’d like to learn more about Belmayne’s approach to managing clients’ money, don’t hesitate to contact me on (01246) 298181 or email: martin.birch@belmayne-ifa.com
