Benstead on Bonds: there’s finally an alternative to stocks

Sam Benstead breaks down why investors are fleeing the bond market – and explains why that could actually be a good thing. 

Welcome to the Benstead on Bonds column, a monthly analysis on the bond market where I focus on the lessons everyday investors can take from what the City’s most sophisticated investors are up to.

Bond investors are considered the “smart money”, hypersensitive to shifts in the macroeconomic environment and laser-focused on getting their money back, rather than finding the next super-star stock.

This means bond markets contain brilliant clues about what will happen to inflation, interest rates, economic growth – and the stock market – while also offering savvy investors income streams and the chance to make money on their capital as well.

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Falling interest rates over the past decade has pushed bond prices lower and squeezed incomes close to zero, or negative in real terms when accounting for inflation.

While bond owners profited, the almost non-existent yields took bonds off the menu for many investors who wanted an income from their “fixed income” investments. And who can blame them? Why would you lend money to a company or a government that would guarantee you a loss in real terms, or after inflation?

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In the meantime, stock prices kept rising, driven by the same factors that push bond prices higher: low inflation and falling interest rates. This backdrop led to a famous City acronym: “TINA” – there is no alternative (to the stock market).

But with the return of inflation, that has all changed. It’s hard to understate just how sharp the pivot from central banks has been from record-low interest rates to rapid rate rises. This has caused investors to sell bonds and their yields to rise.

Take the UK 40-year gilt issued in May 2020 (TREASURY 0.5% 22/10/2061 - TG61), for retail investors, when interest rates in Britain were 0.1% and the 10-year bond yielded about 0.2%.

Costing £100 to buy at the time with an annual yield of 0.5%, the gilt now changes hands for just £30. It has lost 70% of its value due to a change in sentiment at central banks. Or take the 10-year UK government bond. Two years ago it yielded about 0.2%. Now it yields 4.56%.

Yields are only going in one direction at the moment. Interest rate hikes from the European Central Bank, Bank of England and US Federal Reserve, and “hawkish” comments that inflation could become embedded is being taken very seriously, causing investors to sell bonds.

Meanwhile, new chancellor Kwasi Kwarteng is adding fuel to the inflation fire by cutting taxes. His “Plan for Growth” includes scrapping the 45% “additional tax” rate on income over £150,000 next April and changing the basic rate from 20% to 19% on income between £12,571 and £50,270.

He also removed VAT for tourists in the UK, cancelled the corporation tax hike, which would have seen the rate moved from 19% to 25%, and cut stamp duty. 

Following last week’s mini-budget, investors can now get more than 4% annually by lending money to the British government. Savings accounts in the UK offer similar returns for savers willing to lock their money up for at least two years.

A 4% return is nothing to shrug at – it is considered by some financial advisers as the safe withdrawal rate from a portfolio to maintain the value of capital, but does not take into account the effects of inflation.  

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The question on everyone’s mind is whether there is finally a credible alternative to stocks in the bond market, or will it become a value trap, with bond prices set to fall and yields to rise even further?

Peter Spiller, manager of Capital Gearing (LSE:CGT) investment trust, the go-anywhere capital preservation strategy, told me that at these yields, both inflation-linked and normal gilts offer attractive income for investors willing to hold shorter duration bonds (those with lifespans of five years or less) until maturity.

Spiller said: “Gilts are looking interesting for the first time in a very long time, particularly the shorter maturities. The shorter end of the yield curve is more attractive because I think inflation will be higher for longer than markets currently believe. The Bank of England will keep rates high unless there is a housing market crash, but there is no sign of that happening at the moment.”

Longer dated bonds – those with maturities of 15 years-plus – have higher yields. However, this part of the bond market is more sensitive to rises in interest rates. The consensus view at the moment is that the gap between short duration and high duration bonds is not high enough to entice investors to take extra risk. For example, 30-year gilts have a yield of 5% versus 4.7% for five-year gilts.  

Following the rise in bond yields, Richard Woolnough, a bond fund manager at M&G Investments, points out that the TINA argument is dying. He said: “When bond yields were negative they were guaranteed to go nowhere…but now bonds offer reasonable value versus other asset classes. TINA no longer applies. There is an alternative.”

Woolnough adds: “While past performance is not necessarily a guide to future performance, when it comes to bonds – gilts – it is a 99.9% guarantee that bondholders receive the level of income on offer and receive their capital back (when the bond matures). The increase in gilt yields mean that investors are getting paid really well.”

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Another measure of value is to look at the earnings yield on stocks, which measures how much profit is generated by companies as a percentage of the share price, and compare it with the income on offer from corporate bonds.

Woolnough points out that for the S&P 500 and US corporate bond market, both figure are now the same, at about 5%. He calculates that this is the first time since 2010 that this number is the same, meaning that bonds are good value compared with stocks.

So is TINA over? A lot of the value in bonds today hinges on what inflation does over the next couple of years. Paul Johnson, director of the Institute for Fiscal Studies, said that Kwarteng’s budget will fuel inflation and cause the Bank of England to be more aggressive with interest rates. This suggests that rates will go even higher and bond investors may get higher income if they hold off investing.

Johnson said: “Injecting demand into this high-inflation economy leaves the government pulling in the exact opposite direction to the Bank of England, who are likely to raise rates in response.

“Early signs are that the markets – which will have to lend the money required to plug the gap in the government’s fiscal plans – aren’t impressed. This is worrying. Government borrowing is set on an upward path. It will reach its third-highest peak since the war, and remain at well over £100 billion, even once the energy support package is withdrawn.”

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Another pessimistic voice is that of Lawrence Summers, a former US Treasury secretary and government economic adviser. He says that short-dated UK government bond yields could reach 7% as investors lose confidence in the British government and begin to treat it like a developing country.

That said, starting yields could be high enough for investors to stomach any capital losses over the short term.

Chris Iggo, chair of the AXA Investment Management Investment Institute, takes the view that investors should recognise that there is value in the bond market due to high yields, but not jump in and be fully invested just yet.

“Buying high-yield bonds in the three to five-year maturity range with 7%-8% yields attainable looks attractive if you think inflation is going to fall from its current levels. Returns should be higher than inflation over the maturity of the investment.

“But, in the short term the Federal Reserve is in play still and is playing hard. So it might be wise to wait and get paid somewhat lower yields with less risk, or by still owning short-dated inflation-linked bonds to receive the inflation that is higher than we thought it was going to be just a few months ago.”

While bond prices could fall still further, the income on offer – particularly given rising inflation and falling stock markets – makes bonds a genuine alternative to owning shares, finally.

The increase in yields this year has meant that many funds now yield more than 4%, even safer bond funds. FE Analytics, a fund data firm, says 104 bond funds yield more than 4%.

These include ACE 40 recommended funds Rathbone Strategic Bond (4.5% yield) and Liontrust Sustainable Future Corporate Bond (4.2%), and Super 60 members Jupiter Strategic Bond (4.6%), Royal London Global Bond Opportunities (6%), and M&G Emerging Markets Bond (6.5%).