Searching for income in today’s low interest rate environment is challenging – particularly for investors with reducing risk appetites approaching retirement or already drawing down on savings. While it can be tempting to turn to riskier income-generating assets in the hunt for yield, this increases your portfolio’s vulnerability to market shocks – and could result in financial plans going off track.
It’s a downward spiral…
There is an inverse relationship between a bond’s price and its yield. All else being equal, as yields rise, the price of a bond falls. And as yields fall, its price will rise.
As the chart below shows, global bond yields have trended downwards for over 30 years, a trend that has accelerated since the global financial crisis in 2008. Some government bond yields have hovered near zero or, in the case of Germany, fallen into negative territory.
Source: M&G, Bloomberg
This long term fall can be explained by various factors. Lower economic growth and low inflation have a downward effect on bond yields. When inflation is low and stable, investors don’t need to demand as much compensation in terms of yield to offset expected inflation. Additionally, quantitative easing (QE) has kept the price of bonds buoyant as central banks’ own purchasing programmes have helped to drive down yields. Regulation in the UK has also played its part, with insurers and pension funds required to buy gilts which has kept prices firm and yields low.
…and an uphill struggle
This trend has led to bond markets exhibiting longer duration. Over the last 20 years or so, the average duration of global corporate bonds has increased from 5 to over 7 years1.
In simple terms, for every extra year of duration, a 1% change in yields can cause bond prices to move by another 1%. Longer duration magnifies the impact of yield changes on bond prices, and this is especially important in a rising yield environment, when bonds with a higher duration see their prices fall further. What’s more, increases in duration can result in a rise in volatility as corporate bonds are more sensitive to interest rate shocks.
When inflation expectations rose at the beginning of this year, yields for US treasuries and gilts rose, causing a fall in their value. As gilts tend to be longer dated than corporate bonds (with an average duration of around 12 years) they are more sensitive to changes in yields, so their prices fell further than corporate bonds. For example, from January this year till around mid-May when gilt yields peaked, the FTSE Actuaries UK Conventional Gilts All Stocks Index fell by 7.76%, compared to the ICE BofA Global Broad Market Hedge Index which fell by 2.85%2.
Back to square one
However, since mid-May, inflation expectations have eased and bond yields have begun to fall again on the view that strong economic growth, driven from its low base, is expected to moderate. The demand for government bonds also remains strong, which is supportive of low yields.
While yields are a little higher than they were at the start of the year, they remain at historically low levels. This puts bond investors back at square one with their income conundrum – and shows why a diversified portfolio focused on risk-adjusted returns with no overreliance on any one asset makes so much sense.
In our core solutions, we use a mix of managed liquidity, fixed interest, property and global equities to achieve a balance of income and capital growth. Within fixed interest, our clients’ portfolios are invested in UK gilts, UK index-linked gilts, sterling corporate bonds and strategic corporate bonds across a range of fund managers, to provide exposure to the broadest opportunity set.
1TwentyFour Asset Management
2FE from 31/12/2020 to 13/05/2021
This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity. Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.
