Bond Watch: explaining a historic week for the bond market

Sam Benstead runs through the most important news stories of the week for bond investors.

Welcome to interactive investor’s weekly ‘Bond Watch’ series, covering the latest market and economic news – as well as analysis – that is relevant to bond investors.

Our goal is to make the notoriously complicated world of bond investing simpler, by analysing the week’s most important news and distilling it into a short, useful and accessible article for DIY investors.

Here’s what you need to know this week.

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It all began with a mini-budget

Kwasi Kwarteng’s not so mini “mini-budget” a week ago revealed huge tax cuts, particularly for higher earners. The reaction from markets was negative, with bond investors particularly worried about how the government would finance the tax cuts and whether they would stoke inflation higher, which would lead to more interest rate rises.

Bond prices collapsed, sending yields to around 4.5% on the 10-year UK gilt over the next couple of trading days. The pound also fell, reflecting investor doubts about the credibility of the British government.

Normally, when rates go up, the currency rallies too, as investors can buy pounds and deposit them in the UK, bagging a higher return. But this time, bond prices and sterling fell, similar to a confidence crisis in an emerging market government, according to many commentators.

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The moves were so dramatic that the International Monetary Fund (IMF) issued a statement saying that it was “closely monitoring recent economic developments in the UK” and engaging with authorities.

It said: “Given the elevated inflation pressures in many countries, including the UK, we do not recommend large and un-targeted fiscal packages at this juncture.”

Deutsche Bank calculated that it was the biggest five-day move in 10-year and five-year gilts since the 1970s.

And then the Bank of England stepped in

To calm markets, and prevent a brewing pension fund liquidity crisis, the Bank of England stepped in, announcing it would spend £65 billion buying long-dated gilts. This boosted bond prices, sending yields lower to about 4.2% on the 10-year gilt.

The Bank also said it would intervene at “whatever scale is necessary”, showing that a real liquidity crisis had been unfolding.

Bethany Payne, global bonds portfolio manager at fund manager Janus Henderson, says the Bank of England blinked first in its stand-off with the government.

“The Mexican stand-off between the government on the fiscal accelerator, and the central bank on the monetary brake, was won by the government as the Bank of England has had to blink.

“The contagion risks of margin calls, caused by higher gilt yields, meant that a reflexive negative feedback loop into falling UK asset prices had become too high, risking a doom loop.”

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Orla Garvey, senior fixed income portfolio manager at Federated Hermes Limited, adds: “This probably reduces the tail risk of endless stop outs causing real yields to continue spiralling higher.

“But starting quantitative tightening while maintaining quantitative easing will cause confusion around tightening rates. It also doesn’t change that fact there is a huge amount of issuance coming in the years to come, and the Bank of England won't be here to buy it.”

But investors are now more optimistic

After intervention from the central bank, but with more tax cuts teased by Kwarteng, what happens next to gilts?

Some investors see the sell-off as a great buying opportunity. One is Ian Williams, manager of the WS Charteris Strategic Bond fund, who says gilts are now an “outstanding buy”.

Williams said: “In my opinion, the UK gilt market now offers exceptionally good value relative to both UK equities and foreign bonds, such as Italy, which is a true fiscal basket case where Italian inflation-linked bonds now yield less than UK gilts.

“We are heading into a recession in the West and bonds that yield more than equities (especially consumer-facing equities) should be favoured. In 40 years of trading gilts I have never seen the market this oversold. Bear markets usually end on a capitulation sell-off and this one – with long-dated gilts now down 35% in the last five trading days – is the mother of all capitulations.”

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Payne adds that the Bank of England buying long-dated bonds, and therefore showing willingness to restart quantitative easing when markets become jittery, should provide some comfort to investors that there is a gilt yield backstop.