As you can see the major global bond markets all delivered a negative total return during February, but the biggest faller was the UK and gilts. The total return from Gilts was 5% lower in a month and the gilt yield more than doubled from 0.32% to 0.82%.
We have been in an environment of lower interest rates since the global financial crisis and that backdrop seems unlikely to change in the coming years – there has even been talk about interest rates going lower and in the UK’s case negative for the first time in history. So why are bond yields increasing when interest rates look set to stay low?
The starting place – the fear caused by Covid-19 in 2020 pushed investors and central banks to buy more and more safe-haven assets (like government bonds), this meant that bond yields were the lowest they have ever been.
The Recovery is coming – the vaccine roll-out enables life to get back to a pre-Covid world. As announced by the Prime Minister recently – by June it looks likely that we will have no restrictions placed upon us. As restrictions are eased – economic growth is about to explode. There is significant pent-up demand which will propel global growth higher through the course of 2021 and 2022.
Government policy – with interest rates low, governments are looking to stimulate their fragile economies by fiscal policy. The numbers being discussed are huge. The US is close to agreeing to a $1.9 trillion pandemic relief bill.
The fear from bond investors and the reason behind the selloff is because the economic recovery combined with government fiscal policy is going to be inflationary. As inflation picks up, the yields being paid on debt needs to be adjusted high to compensate for this. As bond prices fall their yields increase.
Towards the end of February – this sell-off in government bonds spooked equity investors and specifically high growth companies which can sometimes be priced off a discount rate. Investors look to discount future cash flows to a value today. As bond yields increase, so does discount rates this means the present value of these businesses is smaller i.e. the value of the company is less and their share prices fall.
How is Luna positioned?
Luna reduced their exposure to fixed income securities in November last year – at the same time we increased our allocation to equity markets. We did this because we felt the vaccine news was a game-changer and that it represented light at the end of the tunnel from this Covid impacted life.
In the Summer of last year, we started rotating away from growth businesses and specifically Technology. We like these businesses for the longer term but felt that valuations and the price we were expected to pay for these securities was too much and we wanted to start to reposition for economies reopening. In the early stages of a recovery, more cyclical and financials tend to perform better. As well, we wanted exposure to good quality travel and leisure business that had been crippled by Covid and a reopening could be extremely positive.
Looking forward – the Luna View
Are higher government bond yields a positive? This is further evidence that economic recovery is coming. Investors are positioning away from defensive assets and more towards riskier investments that can perform better in an economic recovery. It is not a positive for everyone though, this will be a headwind for governments – despite record amounts of debt the fall in bond yields has been helpful for governments because it has reduced the amounts needing to be paid on interest. As bond yields move higher as does the amount of their liabilities.
Inflation will increase over the coming months. It is important to remember that we had a negative oil price a year ago when doing an annual calculation today – inflation will be higher. Companies that have survived the pandemic will also be looking to adjust their fees higher to benefit from the reopening. Demand will be high, and we will be less cost-conscious than we have been in the past. This could be good for investing in equities – higher revenue.
Looking longer-term – inflation will pick up over the coming months and year, but we don’t believe this will be a sustained increase. There are still significant deflationary forces around; an ageing population, globalisation and efficiencies being driven by technology and innovation.
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