Spikes in government bond yields have been receiving close attention recently. Their upward movement does not just relate to UK gilts, but a large proportion of the global government bond market, from US Treasuries to Japanese, Australian and European sovereign debt.
Yields on government bonds have effectively been at all time lows since 2008, when huge stimulus packages were pumped into the market and the term quantitative easing first became widespread. However, it was not until 2016 when the yield on a ten-year bond first went below one per cent in the UK and went on to collapse to around 0.5% before gaining ground.
At the height of the market sell off last year, we saw government bond yields fall to new lows, tanking to 0.08% in the UK at the ten-year level. Indeed, some parts of the yield curve fell into negative territory as the Bank of England discussed the knotty issue of moving the base rate to below zero. This pattern has been repeated around the globe.
Given this recent history, what has caused yields to move north again? In the UK, the Bank of England set the ball rolling in early February when it began to adopt a hawkish response to negative interest rates, marking the point at which yields started to rise. At the same time, the prospect of inflation started to become a concern. Oil prices, which in 2020 were in negative territory, started to climb while OFGEM, the UK energy regulator, raised the energy price cap, followed more recently by the hike in the Consumer Price Index (CPI). Inflation is no friend to a fixed coupon bond as it erodes its purchasing power. All the same, despite the fact that CPI numbers are moving upwards, they are still low by historic standards at 0.6%.
We see a similar picture in the United States. The proposed shift to average inflation targets implied that the Fed is willing to let inflation move above its explicit two per cent target. This spooked the market and yields move upwards. This was compounded by a speech by Jerome Powell which, although aimed at providing some level of comfort to markets did anything but that, resulting in yields moving out further. The Fed has since confirmed that they are monitoring this situation and thereby opening the door to intervention should yields move too far.
What does this all mean for investors? Gilts and US Treasuries are widely seen as safe haven assets, or at the very least, the risk-free rate. They are the foundation from which dividend discount models are constructed and provide the basis for credit spreads. As a result, we have seen corporate bond yields shift up. In a balanced portfolio they also have the effect of hedging against a falling equity market. Investors fly to safe haven assets when there is a market sell off, as demonstrated by the seven to eight percent returns we saw from gilts in Q1 2020.
However, with UK government debt comes greater interest rate exposure, otherwise known as duration. The duration of the UK Gilt market is about 13 years, which implies that for every one per cent change in yield, investors will experience a 13% swing in price. This figure is significantly lower for US treasuries – more like seven to eight per cent – which is why this market looks more attractive in our view.
Given we have just experienced an uplift in UK yields of about 0.5%, investors would have lost 6.5% if they invested in the index alone. This loss is nonetheless around half of that an investor would have suffered from a position in US treasuries. From a relative position, this has been beneficial to lower risk portfolios as they have had significantly lower gilt exposure than their benchmarks. However, in absolute terms, the small government positions held have had an impact on portfolio values.
How does this affect our outlook? It is still early to draw any hard and fast conclusions on yields given that we are only now beginning to see them return to their pre-Covid-19 levels last seen at the beginning of 2020. It is very difficult to call which direction they will move from here but we do not believe central banks will let yields move out too far as this will have a severe impact on the cost of servicing their high levels of debt. This is certainly the tone of discussions in the US, where the Fed is keeping a watchful eye.