Jupiter: Why so much volatility in bonds?

Bonds: a suckers’ rally

A month can be a long time in investing, even a short month such as February with only 28 days. The Financial Times must be ruing its headline a month ago today when it trumpeted, “Investors pile in to bonds” when prices soared and yields dropped in response to what investors saw at the time as a more benign interest rate environment emerging. It was wishful thinking.

Over the month of February hubris has turned to dust: investors in the long-dated UK 15-Year Gilt (government bond) have seen the value of their investment drop by 6.3%. In 2022, that same Gilt suffered a 45% impairment.

Government bond yields move in the opposite direction to prices, rising and falling in sympathy with the prospects for future interest rates. They reflect investors’ basic needs to be compensated for the risk that the borrower defaults and they never see their money again; intuitively, rational lenders also require an adequate rate of return while their money is out on loan (though that notion was tested virtually to destruction in recent years when, at its peak in December 2020, 27% of all government bonds in issue amounting to $18.7 trillion dollars, carried a negative yield, i.e. investors were paying borrowers to take their money and by implication were assuming less than zero chance of an adverse outcome; in the case of Germany and as recently as at the beginning of 2022, even on a 30-year outlook!). There are certainly complex and uncertain factors to weigh up in assessing the pricing of bonds in a dynamic economic environment. It may be a highly technical environment but equally the overarching concept itself is not rocket science: it is quite simple, not least because the vast majority of bonds have a fixed repayment date and a fixed coupon (or occasionally some explicitly defined link with inflation) paid at predetermined regular intervals.

Why so much volatility?

You might well ask, therefore, armed with much the same reported economic data available to all to examine and analyse, and with duration and coupons being known and predictable quantities, why is there so much volatility in bond prices?

It is a good question! And the answer is a combination of interpretation and extrapolation of historic data, informed opinion, educated guesswork, often entrenched and polarised views on the outlook and disagreements over the remedies required to deal with existing and emerging difficulties, all seasoned with a hefty pinch of many participants merely following the herd and copying what others do. There is an old market adage, “never bet against the Fed”; but the reality is that to a varying degree there is always tension between investors as the providers of capital, and the central banks as the policy makers who set interest rates, as to who has the whip hand in the prevailing economic conditions.

Back in the autumn, when Kwasi Kwarteng’s budget delivered Trussnomics in such a cack-handed way that it sparked a short-term near melt-down in global bond prices and an equally significant spike in bond yields, it made headlines worldwide. The news channels were all a-twitter. Even the BBC was carrying bond yield charts on the 10 o’clock News when it enjoyed making unfavourable comparisons between the state of the UK economy and the EU’s perennial fiscal basket-case, Italy (in much the same way as it has now found GDP per capita data to make unfavourable comparisons with Poland; look hard enough and there will always be data lurking somewhere to support a case when an axe is to be ground).

Today, as the US government 10-Year Treasury yield breaks through 4% again, and in Germany the equivalent 10-Year Bund exceeds 2.7%, these are yields that in America’s case are very close to last year’s October flash-crash levels, and in Germany now exceed them. For the record, the UK 10-Year Gilt carries a yield of 3.9%, a long way below the 4.5% seen at the worst of the Trussnomics crisis, and now nearly three-quarters of a point below Italy’s government bond. But if five months ago there was an air of near panic, not so now. Today it is merely a recognition that the path to consistently lower inflation may be less straightforward than many had either hoped or predicted.

The shifting economic narrative

It may seem perverse but pushing the momentum behind rising yields is better news emerging on the economic outlook. As business optimism recovers, as measured through a slew of purchasing managers’ indices on both sides of the Atlantic, and with China back as a participating member of the global economy once more after spending so much of 2022 under Covid lockdown, in the aeronautical language employed by Joe Biden the narrative on economic growth has perceptibly shifted from a ‘hard landing’ through a ‘soft landing’ now to ‘no landing’. In English, if recession was previously assumed as inevitable, we are progressing through flirting with recession and heading to the possibility of none at all in the US. That then feeds the notion that with a more buoyant economy than anticipated, the likelihood is that inflationary pressures will persist for longer (not necessarily driving inflation up again, but making it more difficult to bring it down quickly), and that interest rates may therefore need to be higher and to be longer lasting at those elevated levels than hoped.

Cost of capital concentrates the mind

It is important not to underestimate the real costs involved here, bearing in mind that this time a year ago, the Federal Reserve in the US had not even begun raising interest rates from zero (they are now 4.75%), and in the eurozone it would still be four months before the ECB moved away from a negative deposit rate (now +2.5%). These significantly higher funding costs, referred to by economists as the cost of capital, are a real economic burden at every level of society: government, corporate and consumer. Especially when taken in the context of nearly 15 years of very easy access to exceedingly cheap finance and the implicit assumption that when the time came to refinance, it would be equally low cost and straight forward to achieve. Not so.

Here in the UK, the Office for Budget Responsibility estimates that this year the government will spend around £85bn servicing its debt, the highest figure prior to that being in 2017/18 at £41bn. Driving the doubling in funding costs is not only rising interest rates and bond yields but also that 25% of all UK government debt has a direct inflation-linked indexation. In context, that additional cost of servicing the debt against the long-term average of below £40bn a year, is almost the equivalent of the UK’s annual defence budget; when every 1% of income tax here raises £5.5bn, it’s the equivalent of 7.5p in every pound of income tax paid; E&Y estimates the impending changes to the CGT regime will net the Treasury £1.5bn, a drop in the ocean to what is effectively going up in smoke in incremental government debt financing charges. The cost is real; we all pay.

But the effect of higher funding costs is pernicious in the way that its impact lags the policy being implemented. Empirically, it is estimated that every change in interest rates takes an average of 12-18 months to have a measurable effect on consumer behaviour. Essentially those rate rises which were implemented early last year are only beginning to have an effect now; the policy changes being made this month and next won’t be measured until the mid-to-third quarter of next year. Interest rates are a blunt instrument indeed for controlling consumer behaviour. Arguably, the economic pain is not over yet.

For investors, best advice: keep an open mind!

But as we have said before, and at the risk of being dull and repeating it: in such dynamic times and especially with so few anchor-points of reference, it pays to keep an open and reactive mind and to avoid as far as possible painting oneself into a corner which one may later regret. When investing, best not to confuse what you want to happen or think should happen with what might actually happen, especially when events are beyond your control.

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.

The value of active minds – independent thinking

A key feature of Jupiter’s investment approach is that we eschew the adoption of a house view, instead preferring to allow our specialist fund managers to formulate their own opinions on their asset class. As a result, it should be noted that any views expressed – including on matters relating to environmental, social and governance considerations – are those of the author(s), and may differ from views held by other Jupiter investment professionals.

Fund specific risks

The NURS Key Investor Information Document, Supplementary Information Document and Scheme Particulars are available from Jupiter on request. The Jupiter Merlin Conservative Portfolio can invest more than 35% of its value in securities issued or guaranteed by an EEA state. The Jupiter Merlin Income, Jupiter Merlin Balanced and Jupiter Merlin Conservative Portfolios’ expenses are charged to capital, which can reduce the potential for capital growth.

Important information

This document is for informational purposes only and is not investment advice. We recommend you discuss any investment decisions with a financial adviser, particularly if you are unsure whether an investment is suitable. Jupiter is unable to provide investment advice. Past performance is no guide to the future. Market and exchange rate movements can cause the value of an investment to fall as well as rise, and you may get back less than originally invested.  The views expressed are those of the authors at the time of writing are not necessarily those of Jupiter as a whole and may be subject to change.  This is particularly true during periods of rapidly changing market circumstances. For definitions please see the glossary at jupiteram.com. Every effort is made to ensure the accuracy of any information provided but no assurances or warranties are given. Company examples are for illustrative purposes only and not a recommendation to buy or sell. Jupiter Unit Trust Managers Limited (JUTM) and Jupiter Asset Management Limited (JAM), registered address: The Zig Zag Building, 70 Victoria Street, London, SW1E 6SQ are authorised and regulated by the Financial Conduct Authority. No part of this document may be reproduced in any manner without the prior permission of JUTM or JAM. 223