Four thoughts about the ‘new regime’ for bond markets

• A post-QE world makes this an exciting time to be an active manager in fixed income
• It should be possible to beat inflation over the medium term by buying high-quality bonds
• This appears to be a good time to buy short-dated index-linked gilts
• This is not the time to take on too much duration risk

The world has changed. A year ago, the Fed was still buying bonds through QE and holding interest rates at zero. A year later, its balance sheet has shrunk by over half-a-trillion dollarsⁱ and interest rates are nudging 5%. In Europe, rates have gone from negative 50 basis points to +2.5% in just six months, with more to come.

The magnitude and speed of those changes came as a shock to bond markets, which suffered historically unprecedented losses – losses on a scale more usually associated with equities. But if that was a shock, we should not assume conditions will normalise as it fades. On the contrary: we are on the cusp of a new regime for bond markets.

This new regime carries profound implications for the way in which bond managers will need to approach the task of generating returns. The strategies that worked over the past decade appear profoundly unsuited to the next macro and market regime. As we look ahead to this new era, we can make four broad assertions.  

1) It should be possible to beat inflation over the medium term by buying high-quality bonds 

Bond investors are currently being presented with a compelling opportunity. That’s something we haven’t been able to say for a long, long time... During the decade in which QE artificially suppressed yields, fixed-income managers struggled to find reasons to promote their asset class. But after last year’s painful capital losses, yields have re-set to a higher level. Valuations in our asset classes are now attractive in absolute terms and, we believe, relative to equities. In particular, last year’s re-set created exceptional opportunities for fundamental, active managers in investment-grade sterling credit. Yields in this market are at multi-year highs and not too far short of the levels seen in the wake of the global financial crisis.

We can beat medium-term inflation by buying bonds: Bond versus equity yields¹ and UK Retail Price Index (RPI) – 1 yr tenor²

Today, we can lock in yields that are meaningfully above the market’s medium-term expectations for RPI inflation by buying investment-grade and high-quality (BB rated) high-yield bonds. We can generate positive real yields over the medium term without having to reach into lower quality credit or to take on too much duration risk. The yield on our portfolio at the end of February was a touch above 6%ⁱⁱ.

Last year’s repricing also means that ‘plain vanilla’ fixed-income assets, which have been tested through multiple cycles, look attractive relative to more exotic assets (such as private credit) to which investors turned in near desperation as yields disappeared from mainstream fixed-income markets. There is no longer any need to pursue complexity to achieve a meaningful yield.

The additional yield private debt markets once offered relative to high-yield bonds has disappeared

2) This appears to be a good time to buy short-dated index-linked gilts 

In late 2021 we had minimal – or even negative – exposure to government bonds. Today, however, they account for almost a third of our portfolio. Why the change? Valuations are one part of the story. For example, a year ago, five-year index-linked gilts appeared deeply unattractive, offering a yield that was 3.5% below RPI. Today, in contrast they offer a positive real return above RPI and CPI: that’s a compelling real, risk-free return for the life of the bonds. 

Compelling valuations: UK 5 yr inflation bond – from RPI minus 3.5% at the start of 2022 to above RPI yield

The other part of the story is the risk of recession; the magnitude and speed of the tightening have been such that we cannot rule out the possibility that central banks have tightened too far, too quickly. Should there be a recession, our government bonds would represent a valuable diversifier. 

3) This is not the time to take on too much duration risk

With recession a possibility and with valuations in some parts of the government bond market looking compelling on a risk-adjusted basis, the Artemis Strategic Bond Fund is currently running with around five years of duration – up from less than four years of duration as 2022 began. That’s a significant change. So why not add even more duration to the fund? Why not increase that to, say, eight or nine years of duration?  

The first reason is that we want to run a balanced, diversified portfolio. If we were to take its duration up to eight years or more, we would risk making the fund one-dimensional: its returns would, in effect, be largely dictated by moves in interest rates. That isn’t what we believe a strategic bond fund should do.

The second reason is that, while valuations look attractive, technical and fundamental factors look distinctly less favourable: 

Technical factors

 Government financing requirements across the West remain at elevated levels. Meanwhile, central banks are stepping back from their role as price-insensitive buyers of government bonds – and becoming net sellers instead. 

The net supply of gilts is set to increase from c£100 billion to £200 billion per annum: Gilt supply net of QE purchases and BOE reinvestments

To get a sense of how important that change will be, consider that the Bank of England absorbed almost 60% of supply from the Debt Management Office between 2009 and 2021. 

Fundamentals

 The benefits of globalisation are fading – and even reversing. For the last 20 years, inflation in the West was suppressed by imports of cheap goods and cheap labour from China. But with the differential in labour costs between China and the US having narrowed dramatically, that disinflationary dynamic is fading. Add to that higher energy costs (due to the West’s need to simultaneously improve its energy security and transition to low-carbon energy) and any assumption that today’s inflation will simply evaporate appears optimistic.

So, although we have taken the fund’s duration higher, we haven’t taken it to extremes; the outlook for the long end of the curve looks too challenging. And, just as importantly, we want the fund to continue to deliver on the original promise offered by strategic bond funds: to spread risk and harvest diversified returns across the world’s fixed-income markets.

4) A post-QE world makes this an exciting time to be an active manager

For over a decade, the actions of central banks – particularly QE – have been the dominant factor shaping returns from financial markets. And although we are approaching the end of the current rate-hiking cycle, a potentially more significant process – quantitative tightening – has only just begun. Freed from the flattening influence of price-insensitive buying by central banks, the market is becoming more discriminating between different bond stories. We can see the early stages of that process in the rise in dispersion of returns from a very low base. 

This makes today an exciting time to be active manager in the credit market. Under QE, everything went up in unison. Fundamentals didn’t much matter. But as funding costs move higher, business models that relied on unlimited cheap funding are coming unstuck. This is a completely new environment for company management teams – and for managers of bond funds. 

In these conditions, having the expertise to focus on fundamentals is more relevant than it has been for at least a decade. As monetary tightening continues, the importance of research and active credit selection undertaken by specialists – the approach we apply to running the Artemis Strategic Bond Fund – will only continue to grow.