23 Aug 2022
There was a big rise in UK government bond yields last week, reflecting the inflation data which came in above expectations.
Headline Consumer Price Index (CPI) hit 10.1% in the year to July, the highest level in 40 years. Fuel and food once again put upward pressure on prices but there was also a rise in core CPI with rents and leisure services leading the way. More worryingly, it looks like the UK is becoming an outlier. US inflation may have peaked and the recent declines in oil prices and agricultural commodities will help in coming months. In the UK, conversely, inflation is expected to move higher in Q4.
How did interest rate expectations move? Despite the Bank of England’s (BoE) recent warning of an impending recession, investors refocused on the inflation threat. Looking at the short end of UK government bond markets we can see that a 50bps hike is assumed for September, with further rises priced in over the next six months and a peak around 3.75%. As expected, the short end of the yield curve has been negatively impacted by this re-assessment with two-year yields now at their highest in 14 years. But in capital terms the real damage has been at the long end. If we take the benchmark 40-year gilt, issued in May 2020 at £100 with a 0.5% coupon, it traded below £50 last week. Put simply, a move up of 2% in yields on a low coupon 2061 bond has resulted in a 50% decline in price over two years.
Credit quality vs interest rates
The same outcomes can be seen in the longer end of credit markets. Last week some of our funds added to high quality long-dated bonds such as Wellcome Trust and Oxford University. In both cases the prices paid were 25% below their initial sale price and more than 50% below their peak 2020 prices. The issuers are no less credit worthy but the change in interest rate expectations has been powerful.
The university bond sector has seen growth in recent years with many institutions raising both public and private debt. And you can see why. In 30 years, the number of students entering higher education has nearly doubled. The dislocation caused by Covid and the return to public examinations has been a particular challenge for the student cohort getting their A-level results this week. Good luck to them, especially those entering clearing. While not espousing the Jeremy Clarkson approach to education (“I got a C and two Us and I’m currently holidaying on this boat”) it is important to recognise that employers look for more than just intelligence. Team working, drive, adaptability, resilience are all important. Looking at our intern programme I see these traits and feel really impressed with the wider skills on display.
Bond yields still rising
Compared with the UK, the rise in US treasury yields was more muted although the 10-year rate nudged 3% before closing around 2.95%. In Europe there was a material rise in bond yields, particularly in Italy where 10-year bonds finished at 3.5%. Implied inflation was mixed across markets although there was a further rise in the UK. Since mid-July 20-year breakeven inflation rates have hardened by nearly 50bps – surprising against a weakening economic background. What should we read into this? One interpretation is that the BoE will now go soft on rate rises and that inflation will be tolerated at higher levels. This is not consistent with the change in interest rate expectations. It could be that a looser fiscal policy is being factored in either under Prime Minister Truss or a new government post 2024. Or it may be that in illiquid markets movements become distorted, either to the downside or upside.
Credit spreads were wider on the week although activity remains pretty subdued. Overall, I feel that markets look a bit disjointed with asset classes reflecting different economic outcomes. I have been surprised that equity markets have not been more negatively impacted by the rise in real yields seen this year and that the rally in high yield has materially outpaced that seen in investment grade. On the ground feedback from corporates is reasonably upbeat but when I look at the headwinds facing businesses, I wonder whether this is backward looking. A combination of higher costs and weakening demand is not a great outlook for corporate earnings. In my view, higher quality credit bonds look reasonable and I expect that our world leading universities will continue to pay their coupons on time.
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