Bonds and fixed interest - back to fight another day?
Traditionally, fixed interest securities/bonds, particularly government bonds (gilts), which is usually their safest form, were seen as the standard hedge within client portfolios against the more volatile risk of equities.
However, after the global financial crisis 10 years ago and the introduction of quantitative easing (QE), it became harder and harder to justify holding fixed interest securities in client portfolios due to their lack of yield. Cash was the better defence against equity market falls – despite yielding nothing, it was also free from capital risk.
Yet, as we look across the Atlantic, there are signs that this tide might be turning.
What's happening in the US?
The US Federal Reserve is more advanced than nearly every other central bank in moving towards policy normalisation by incrementally and gradually increasing interest rates while simultaneously selling back some bonds to the market. This has driven up yield on the 10-year US Treasury bond to 3.2%, well in excess of US inflation at 2.3%. Even the yield on two-year US paper at 2.9% now surpasses this. For the first time in years, US investors can get a real return from their national government bonds.
This is causing us to consider whether government bonds might resume their risk-diversifying role and warrant a place in client portfolios. As well as moves to policy normalisation and rising interest rates starting to help bonds fight back, historically, when market turmoil hits shares, gilts have been seen as a safe haven asset that tended to hold their value and/or even go up in price. If 2019 equity markets continue their turbulent path, there could be good reasons to turn to this out-of-favour asset class.
Do gilts offer good investment opportunities for 2019?
To answer this, it is important to reflect on gilts' recent track record – and what needs to be addressed if they are to win us over.
Since the global financial crisis, the world’s central banks have been conducting an unprecedented experiment in monetary policy. By crunching short-term interest rates down to zero – or below zero in the case of the European Central Bank, Switzerland, Sweden and elsewhere – while buying up quantities of fixed interest stock, central bankers drove longer-term interest rates to unparallelled low levels. At its zenith, QE meant that around US$13trn of bonds worldwide yielded less than zero.
What can we learn from the markets?
The FTSE Gilts All Stocks Index, including interest payments, has now fallen 5% from its high in August 2016. With the yield on the UK 10-year gilt still only 1.5% today, there may be some way to go before private client investors are tempted back into the UK fixed income market; still more so in Japan and Europe, where yields are significantly lower. The uncertainty around how Brexit will play out also complicates the picture.
But it is very often the case that, both in equities and bonds, market direction is led by what happens in the US. So as US government bonds start to offer investor opportunities once more, and increasingly resume their traditional risk-diversifying role, the moment may be drawing closer when the same will be true here in the UK.
Investing in 2019
We’re certainly not there yet, but we believe bonds are a key investment theme to watch in 2019.
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IMPORTANT: Investment involves risk. The value of investments and the income from them can go down as well as up and you may not get back the amount originally invested. Past performance is not a reliable indicator of future performance.