Commentary by Roger Hallam, Global Head of Rates, Vanguard, and Kelly Gemmell, investment product manager, Vanguard, Europe.

 

  • The recent sell-off in UK government bonds highlights how we could be entering a new era for fixed income markets.
  • Amid tightening financial conditions, global bond markets have little tolerance for policy missteps.
  • As yields rise, the risk-reward profiles of different sectors of the bond market are more attractive than they were six months ago.

 

With global fixed income markets already coming to terms with the new era of tightening monetary policy, in late September market concerns around the UK government’s ‘mini’ budget caused yields on UK government bonds (or gilts) to spike to multi-year highs.

The Bank of England (BoE) stepped in to buy long-dated gilts to preserve financial stability and the government has since appointed a new chancellor, who has reversed much of the ‘mini’ budget. This appears to have calmed markets, although yields on gilts (as well as on other core government bonds) remain elevated. While yields may now be at more attractive levels, many global bond investors are now wondering whether, in this increasingly unforgiving market environment, the recent volatility will continue.

A less forgiving market

While gilts have come under pressure, the UK bond market is not the only one to have sold off heavily this year. From a global perspective, bonds have had a torrid time, with the Bloomberg Global Aggregate Bond Index down 3.86% for the third quarter and 13.79% for the year to date to the end of September1

The obvious driver is major central banks who—with the US Federal Reserve (Fed) at the forefront—have continued to hike interest rates to combat broad-based inflation, and bond yields have marched correspondingly higher. In addition to this, policymakers are unwinding years of ultra-accommodative policy, reducing their balance sheets through quantitative tightening (that is, selling, or allowing to mature without reinvestment, bonds they had previously bought as part of quantitative easing measures). For example, the Fed’s current target is to reduce the size of its balance sheet by $95 billion each month.

For global bond investors, this is potentially ushering in a new epoch – one in which under-pressure markets are much less tolerant of missteps that they might have let pass under easier conditions. And we believe the UK gilts sell-off is symptomatic of this new, more punishing market environment.

Similarly, markets are also likely to become much more willing to call out management errors and fundamental weakness in the case of corporate issuers. If this is the case, we believe that credit research could become even more important as dispersion between issuers increases.

It has also raised questions around how certain parts of the global financial system that have grown accustomed to more than a decade of easy monetary policy and low interest rates might respond to persistently tighter conditions. For example, alternative and private credit markets have become increasingly significant parts of the financial ecosystem in recent years2.

The gilt sell-off has exposed the liquidity challenges that large market moves can cause as the counterparties in a particular financial chain are forced to sell assets in quick succession.

Global investors should brace themselves, as there is probably further volatility ahead. Monetary policymakers have made it abundantly clear that little else matters until price stability is attained. In the UK, the government’s tarnished credibility in the eyes of investors and the issues with rebalancing in pension schemes that use liability-driven investment (LDI) mean that over the near term, volatility is likely.

But the current environment does have an upside for investors - the risk-reward profiles of different sectors of the market—government, corporate and emerging market bonds, for example—are more attractive than they were six months ago.

The implications for government bonds

From a UK perspective, the BoE’s intervention in bond markets underscored the institutional strength backing gilts that many bond investors prize. The rapid and measured actions of the central bank to reassure markets as UK rates sold off has enhanced the standing of the BoE, in our view.

And central bank credibility is one of the core principles underpinning the effectiveness of monetary policy and well-functioning sovereign debt markets, as followers of emerging debt markets will know.

Similarly, the negative market reaction to the government’s initial neglect of the input of independent fiscal watchdog the Office for Budget Responsibility has highlighted this institution’s importance in helping to keep UK public finances on a level footing.

From a valuations standpoint, UK bond yields are arguably more appealing they have been for many years, providing a higher starting point for total returns. At current yield levels, they also offer the potential for much more effective risk-dampening qualities relative to equities – one of the key properties many investors seek in fixed income.

Elsewhere, government bond valuations have also improved. For example, for years, yields on 10-year US Treasuries languished below 2% and lagged the dividend yield offered by the S&P 500 equity index. But by the end of September, the 10-year Treasury yield was roughly double the dividend yield offered by the S&P 5003.

Bond yields outpace dividend yields

Source: Factset. Data from 30 September 2022 to 30 September 2022.
Notes: This chart compares the yields of the Bloomberg U.S. Corporate Bond Index, the 10-year US Treasury note and expected forward dividends of the companies in the S&P 500 Index. As of 30 September, the Bloomberg U.S. Corporate Bond Index yield stood at 5.69%, the 10-year Treasury yield at 3.80% and the dividend estimate for the S&P 500 was at 1.90%.

And in terms of liquidity, despite initial fears about the impact of sharply ascending yields on LDI investors and the broader market, Vanguard has been able to continue to provide best execution to our clients by leveraging our scale and strong trading relationships with counterparties in fixed income markets.

The implications for corporate credit

For corporate credit, there remain challenges ahead. While some core government bond valuations are now attractive, and corporate bond spreads have widened, there is potential for spreads to widen further as economic growth slows and a recession bites, which would be a hurdle for the broad credit market. Nevertheless, higher yields will ultimately provide better shock absorption against market turbulence.

Many investment-grade corporates have maintained strong balance sheets and have been more disciplined in their financing than in prior cycles and, outside of a large market downturn, we feel a broad wave of ratings downgrades is unlikely. In this environment, we believe that the best approach from a risk-reward perspective is to focus on a core allocation to higher-quality, defensive credits that are less sensitive to a weakening global economy.

However, elevated market volatility is also creating more dispersion and giving rise to better entry points among lower-quality bonds, provided, of course, that they are selected on an individual basis and with care.

The high-yield market has gone through several default cycles over the last decade, which has left the sector more resilient, although current spread levels do not broadly provide adequate compensation for the risks, in our view. Rather, our preference is for the higher-quality tranches of high-yield debt markets, with security selection likely to be the most important driver of performance in the coming quarters.

The implications for emerging market credit

In emerging market credit, meanwhile, valuations look attractive in the aggregate, but we see a wide dispersion across issuers, and we are particularly selective when it comes to emerging market high-yield credit.

As the Fed approaches the end of its current hiking cycle, we expect to see additional opportunities in local-currency emerging market government bonds, while currency exposure may also offer pockets of value, should the US dollar begin to weaken.

Lessons for active investors

For active investors, the recent slump in gilts carries several important lessons. One is that making excessive directional bets in an attempt to generate returns—which can at times fare well in risk-on scenarios—is liable to falter in more volatile environments. The recent disorder in UK bond markets is a perfect example of such an environment.

Another is around security selection. While credit spreads have broadly widened, markets are in a punishing mood. Against a backdrop of global monetary tightening, not all credit issuers will be equally well prepared to weather the storm of rising financing costs. As a result, taking a defensive, disciplined and discerning approach to active fixed income, grounded in bottom-up security selection and relative value, is crucial. This has always been at the heart of our approach to active fixed income, in all market environments.

Written in collaboration with Kunal Mehta, head of fixed income specialist team, Vanguard, Europe.

 

1 Source: Bloomberg Global Aggregate Bond Index (performance in US dollar terms). Data from 30 June 2022 to 30 September 2022 and 30 June 2022 and 31 December 2021 to 30 September 2022.

2 Source: BAML, 31 August 2017 to 31 August 2022. The face value of the loan market rose from $929 billion in August 2017 to $1.425 trillion in August 2022, a compounded annual growth rate of 8.9%.

3 Source: Factset. As of 30 September, the 10-year Treasury yield stood at 3.80% and the dividend estimate for the S&P 500 was at 1.90%.

Investment risk information

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Past performance is not a reliable indicator of future results.

Some funds invest in emerging markets which can be more volatile than more established markets. As a result the value of your investment may rise or fall.

Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.

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