It’s time to leap into the void. This column has spent the past month pondering the funds that I own — covering UK, Asia and US equities along the way. Now let’s turn to what’s missing. One gaping hole is fixed income. Hundreds of readers have asked if I have anything against bonds. No, not really, but I do not like investments which may go down in price. And 2022 seemed to me like a bad year to lend money to governments and companies.
Turns out it wasn’t just bad. It was shocking. A basket of global sovereign bonds is down almost a fifth despite the recent rally. Even lowest-risk-of-all US Treasuries have dropped by double-digits since January. Investment-grade corporate debt also lost investors a chunk of their money, while high-yield paper reminded us why the asset class used to be called “junk bonds”.
So why the sell-off in fixed income this year? And am I now tempted by lower prices to address this cavern in my portfolio? It is the biggest asset class in the world after all. The answer to the latter question is yes. But to understand why we need to examine what moves fixed income markets in the first place.
Bonds do people’s heads in. Coupons, yield curves, credit risk, term premia, duration . . . no wonder we prefer to talk about stocks or real estate or crypto. Even cash-rich Apple had 10 different corporate bonds in circulation as per its last quarterly filing, each with its own payout profile, maturity and yield. Next time you’re at lunch with your financial adviser, ask them to calculate the yield to maturity of your favourite 10-year gilt. Er, waiter . . . bill please!
Indeed, most retail investors wouldn’t be sure if their coupon payments rise or decline with higher or lower interest rates (they do neither) or are inflation protected (they mostly aren’t). That said, newspapers such as this one often remind us that bond prices going up means yields are falling and vice versa. Likewise, we’re always told to diversify — that bonds are lower risk than equities and therefore having a mix of both is sensible.
I’m an equities guy who has spent almost three decades listening to fixed income colleagues. Here’s my take. Let’s start with sovereign bonds. They are low risk because, unlike you or me, governments have a monopoly on the means of violence — as sociologist Max Weber puts it — so they can easily raise enough money to pay investors back. Superpowers especially so.
The coupons will keep on coming, therefore — which makes so-called “govvies” safe. Enforceable contracts also help, as does a stable political system with a long record of sound public finances. Avoid Argentine bonds, then. But supposedly grown-up nations sometimes screw fixed-income investors too. This risk is one reason I haven’t owned any government bonds for a while.
Our 21st century belief that no one should ever suffer has meant that developed nations have racked up huge debts due to financial crisis bailouts, rising welfare costs, Covid handouts, and so on. Owing more than 100 per cent of your gross domestic product, as many countries do, is not unprecedented, however. Even the US had a ratio this high after the second world war.
There are three ways to tackle big debt burdens. Raising taxes or cutting spending are unpopular. Which leaves what economists call “financial repression”. This can take many forms, but usually means keeping government borrowing costs (interest rates) lower than inflation, such that debts shrink in real terms. In other words, countries are bailed out by investor schmucks who earn a lower return than they should on their bonds.
Can’t happen? the US capped long-term interest rates for nine years until 1951. Lopped its debts down to size nicely it did. But 10-year Treasuries failed to make a real gain for 40 years after the second world war. A straight transfer of wealth from savers to Washington. It’s not what your country can do for you, all right.
Where does that leave us now? And why am I keen to fix a bond-sized gap in my portfolio? After one of the fastest tightening cycles in history, I’m in the camp that rates are nearing a top and thus yields will ease next year (that is, bond prices will rise). This week’s benign inflation data out of the US supports this view. I also keep a super long-term chart of US yields on my wall and the historical trend is downward, as you can see in the chart.
The price of money seems to be getting cheaper and cheaper, and that’s good for fixed income. OK, real yields still suck today, with inflation in many countries above nominal yields on bonds. Hence we must remain vigilant that governments aren’t repressing us down the swanee. But if policy rates are near their peak, future returns (the coupons I receive plus any price gains) should be attractive.
Some readers may wonder why many bond funds have the word “aggregate” in their name. It is because they hold a mix of government debt, as described above, and corporate credit. We cannot ignore the latter as it accounts for a third of the $130tn global fixed income market. My problem with corporate credit is that I’ve yet to see how the asset class copes with normalised interest rates. I’m also a tad nervous about company cash flows, from which coupons are paid.
To be sure, corporate bond yields are elevated now to reflect these concerns. Funds invested in the higher-risk credits of UK companies, for example, are spewing out a double-digit annual yield these days. Tempting, but I already have plenty of corporate exposure via equity funds. Another time, perhaps.
I hereby give notice then. I’m going to move the last of my cash, currently sitting in a sterling money market fund, into government bonds — probably Treasuries. I know the US is good for it.