Bond markets: the impact of monetary policy and how we are positioning our portfolios

Rates seem to have dominated the news in the bond market this year. Is that a fair assessment and how has it affected you?

Yes, we’ve spent a lot of time thinking about monetary policy and our duration positioning. Investors started the year expecting several cuts from the Fed and the European central banks. Market pricing was for six cuts (from 5.5% to 4%) in the US and about the same number in Europe. Now, pricing suggests something around 50bps for the ECB and the Bank of England (BoE) and maybe not even 25bps from the Fed.

Growth data has been better and monetary policymakers have talked up rates, so that’s been a headwind for government bonds. Despite quite high starting yields, total returns on Treasuries, Bunds and Gilts have been negative. The Gilt index was -5% for the year to the end of April (it’s come back a bit since).

Government bonds were strong in the last months of 2023, so the market was probably due a breather, but there’s no doubt that duration has dragged on returns.

We held a lot of duration at times in 2023 but I reduced it in Invesco Corporate Bond Fund (UK) and Invesco Sterling Bond Fund at the end of the year, into the big rally. I’ve increased it again as yields have risen this year. So far, that hasn’t worked. It feels a bit like last year. We built duration when yields were high but we didn’t gain from it until the market finally turned in Q4.

So what’s your view on duration now?

We’re positive. Duration has been a drag on returns year-to-date, but I’ve felt comfortable adding at these yields. If rates stay where they are, that’s okay. If expectations for cuts increase, we should do well.

Do you think Europe will cut first?

Yes, in my view they probably will. The macro background makes it easier for them. Growth is slower, so they have more justification for cutting, and lower forecast inflation gives them room. In the most recent meetings, both the ECB and the BoE have moved towards a cutting stance.

It’s unusual. The Fed has normally been the first to move and the central banks don’t seem to like getting much out of step with each other, but I think the market is right to price in some cuts from both the ECB and the BoE in the next few months.

I’m holding virtually zero USD duration. When we’ve added, there has been better value in gilts and I’ve been comfortable with that. But one thing to remember is that there’s a difference between not holding USD duration and the Treasury market not influencing your portfolio. The Treasury market is always important. If there is a big move in Treasuries, Bunds and Gilts will move too.

Talking of gilts, another topic that’s popular now – what’s your view on index-linked compared to conventionals?

We’ve added some linkers this year. With all the focus on how sticky inflation might prove to be, there’s a natural interest in the hedge they offer. I think valuations have improved. Linkers have underperformed conventionals for the last few quarters as inflation has moderated. The breakeven rate (the expected rate of inflation implied by the pricing of index-linked bonds) is looking more attractive. There are also technical factors that I think are supportive. A lot of conventionals are going to be issued but supply of linkers looks more constrained. There must also be pension funds thinking about locking in to index-linked yields.

What about cash? Aren’t you tempted by the yield at the front end of the curve?

It’s certainly an easy argument to make. GBP 3mth is over 5% and there’s no rate risk. But our reasoning for being further out the curve, despite the lower yields, is the same as it was a year ago. First, the short-end yield is high now but how long can you lock it in for? What rate will you get when you need to re-invest? And second, by holding duration we get more than just the yield – we get sensitivity to change in rate expectations. That’s what duration is. If expectations fall, our funds, with a duration of 6 or 7, will get a lot more capital return than short-dated investments.

That’s not to say that we are making no use of the short rates that are available. I have a few percent of my portfolios invested in short-dated corporates. It’s not the same as cash, but I see it as a source of liquidity if I need it. With a bit of spread on top of the gilt curve, my all-in yield is 5.5% on a group of high-quality corporate bonds that will roll off over the next year.

What are you thinking about credit, more widely?

I feel like there’s not much to talk about in the credit markets, from a top-down view. Spreads are a lot tighter than a year ago, but they are also quite stable. There’s been lots of investment grade issuance but it’s been well received by investors.

I think that there’s limited value and prefer the ‘reward to risk’ ratio in higher quality credits. I’m more comfortable with the yield (and the potential upside) I’m getting from rate risk than from credit.

Over the last few months, the theme in my portfolios has been de-risking on credit. Adding those short-dated securities is an easy call. We’ve also been reducing subordinated insurance (RT1), selling and also not replacing when bonds have been called.

We’ve been rotating out of high quality names where the spreads have tightened. In weak periods over the last couple of years I’ve used bonds like Shell 1.75% 2052, University of Oxford 2.544% 2117 and Wellcome Trust 2.517% 2118 to add duration and some high quality spread at good prices. But now I don’t see much upside on their spreads and so I’ve been selling and buying gilts instead (to maintain duration). This is not really about any credit worries, just a valuation call.

I think banks still look reasonably cheap. We’re holding more in that sector. We’ve often been enthusiastic about subordinated banks debt but now I’m more focused on the seniors. I’d say we’ve rarely had as much sterling senior bank paper in Corporate Bond and Sterling Bond. You get a little less yield but the risk mitigation from being so high up the capital structure, along with the quality of the names I’m holding, makes it an attractive option on a reward to risk basis.

Overall, the market is feeling tight and I’m trying to be disciplined on what I buy. There have been some interesting stories at the issuer level, which we’ve been following closely.

What are you looking for from here?

We’ve been early on de-risking on the credit side. Credit spreads have remained quite tight but I think there will be an opportunity to add credit at weaker levels and I’m happy with the portfolios I have.

A stable market is fine for us. We’ve moved to having a bit more rate risk and bit less credit risk, but the all-in yield is good, just a bit under 5.5% on a gross basis. If things stay as they are, that’s okay.

With our positioning, we’ll probably underperform if spreads tighten more. We’re also more likely to outperform if more rate cuts get priced in and we get capital return from our duration.