Louis Hutchings, Investment Analyst, Nedgroup Investments writes that the government bond is an asset synonymous with safety and security, yet actively overlooked and avoided in the years that followed the Great Financial Crisis.
Of course, this should be of little surprise when considering the immediate aftermath of the crash in 2008 saw real government bond yields (the yield received when subtracting the impact of inflation), turned negative for the first time as central banks flooded the market with liquidity.
What really put the nail in the coffin though, was that this market abnormality not only persisted, but worsened. With governments later issuing new bonds which guaranteed that an investor would lose money, even before accounting for the effects of inflation.
That is, an investor was paying to lend. Good luck trying to explain that to your grandchildren.
Fast forward a decade, and rising prices across the globe have forced central banks to engineer the most aggressive rate hiking cycle most of us have seen in our working lives.
Government bond yields have surged higher, and bond prices plummeted, the latter doing little to get bonds back into investors’ “good books”.
This price movement, however, is to be expected. If we look back to the rate hiking cycles that have occurred over the last 30 years, the average return for the 10 year US Treasury index is -2.6 per cent.
Furthermore, broadening the analysis to include the three months prior to lift off (accounting for the fact that markets typically price in rate hikes before they actually happen) the average return is even more negative at -5.2 per cent.
But before you write them off completely, better fortunes may lay ahead for sovereign debt as we converge onto the Fed’s pivot point. Particularly when considering bonds have been 12 per cent better off on average, in the year following the peak of a hiking cycle.
The issue facing government bonds right now though, is inflation. It is hard to convey the level of antipathy bond investors hold towards a general increase in the price level. But rest assured, it’s high.
The fixed nature of the interest and principle paid to a bond investor fails to adjust for unexpected changes in inflation, and therefore the value of these payments are directly eroded as the general price level increases.
Fortunately, there is a solution, as inflation-linked government bonds can more than make up for this fallibility.
After all, their safe haven status mean that they offer everything a typical bond does in terms of diversification, whilst ensuring returns are real, not nominal, by adjusting coupon and principle payments by a standard measure of inflation, such as CPI.
But then why in a year dominated by inflation, have index-linked bonds fallen just as much as their nominal cousin?
Put simply, the ideal environment for index-linkers is one where inflation is running hotter than expected, whilst interest rates are being held constant (or indeed falling). This year has of course seen inflation shoot upwards, but so too have interest rates, the net result being poor performance overall.
You would be right to wonder if the aforementioned “ideal” environment exists. After all economics 101 tells us that central banks dislike inflation just as much as bond investors, meaning inflationary pressures are often met by interest rate increases.
There are however scenarios where this relationship does not hold. One centres around misjudgement, where central banks fail to appreciate the persistence of inflation, refrain from raising the base rate and commit policy error. Think back to the end of 2021, does the word “transitory” ring a bell?
Another is more closely related to inaction out of necessity. An example being when economies are moving through a period of stagnant growth and higher-than-expected inflation (un-affectionately known as stagflation), and central banks are forced to hold rates steady out of fear of choking already lacklustre demand.
It is not inconceivable, that the second of these scenarios is on the horizon.
Looking back across 37 developed and emerging market countries over the last 70 years, we can see that when inflation hits the 8 per cent mark it typically remains at quite high levels.
It is also widely accepted that global economies are slowing. The UK and Europe are, for all intents and purposes, in a recession right now and the US may not be far behind.
The reasonably precarious position many nations currently find themselves, means that any further negative shock could easily push them into a stagflation scenario.
In such an environment, inflation-linked bonds would be very much in vogue.
Their safe haven status would match that of a traditional government bond, whilst their inflation linkage would ensure that they ultimately come out on top.
If, however, inflation does come down quicker than history suggests, and instead tracks Bloomberg market estimates. Then traditional governments would also generate attractive returns, especially in a slower growth environment.
So despite many “falling out” with bonds over recent years, it may well be time to welcome them back in from the wilderness.
Since those that don’t, may be left wanting.
