Broomer's Blog

From the category archives: Bonds

Bonds

When the Curves go Topsy Turvey

When I started out in this industry (and frankly for many years after then), I used to get very confused about yield curves, particularly when they get inverted. Thankfully, I now realise that it's quite simple.

The yield curve graphically describes what the interest rate is at various time points. So starting with bonds very close to maturity such as the 3 month gilt (or treasury bill), we can find an effective rate for a short term investment. As we extend the maturity rate, we can find the rates for 1yr, 2yr, 3yr etc bonds. Typically, curves go out as far as 30 years.

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Redefining the term ‘Investment’

If I offered to borrow money from you with no interest payments and promised to pay you back less than I borrowed in 10 years time, I guess that you would tell me where to go. I suppose you might be prepared to make such a loan to a family member or possibly a very close friend, but you certainly wouldn't consider it an investment.

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It's not Friday 13th but...

Financial advisers are understandably running scared of the conventional gilt market. Instead many have turned to the indexed linked market seeking safety from growing global inflationary risks. For me this is liking watching the victims of a horror film trying to scramble away only to place themselves in ever greater mortal danger. The index linked gilt market has a scary duration that leaves it extraordinarily sensitive to changes in real interest rates.

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A Treasure in Treasuries

Government bonds come close to the ideal complement for equities in a balanced portfolio. They provide both a steady income and the potential for capital appreciation at times when equities might be stumbling. Indeed few, if any, other assets provide this sort of diversification benefit. However, with gilts currently trading on such paltry yields, managers of balanced portfolios have been left in a quandary, since UK government bonds now provide little in the way of income and scant potential for capital return if the economy slumps.

We estimate that 10 year gilt yields need to be close to 2% to ensure that they will buttress a portfolio meaningfully in the event of a recession. Of course, we could look to the more sensitive longer dated issues, however, these bonds are extremely vulnerable to any revival in inflation and so compounds the asymmetric risks inherent in such rich valuations.

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