Are govvies as exciting as murder in the Mediterranean?

I have just been watching Ripley, on Netflix. I hadn’t read the book nor seen the film, so came to the story fresh. I thought it was one of the best pieces of television I have seen for some time. As a ‘Boomer’, of course, I remember when everything was in black and white (sorry ‘monochrome’ as the arty types now call it) so wasn’t put off because the sea wasn’t azure blue.

Of course, it was a slow burn over eight episodes, unlike the two-hour rush that was the film. (I watched the film afterwards for a contrast.) Yes, Matt Damon was younger than Andrew Scott and the sea was very blue, but the acting and the story were much shallower, in my opinion.

Sometimes it’s the less showy that wins. Which, in a very roundabout way, leads me to me to our slow-burn love affair with government bonds. Do you remember them? They used to be the low-risk, boring part of a portfolio that you had to hold as they were part of the benchmark. You might make a low-single digit return, but you held them just in case the more exciting equities tanked.

Well. Over the past two years they have been anything but boring. They have been highly correlated to equities as the markets try to predict peak rates and then price the likelihood of future interest rate cuts. In fact, government bonds and rate-sensitive sectors like REITs (real estate investment trusts) have been moving practically in tandem.

On days when published economic data suggests weaker growth, investors get hopeful that inflation will continue to sink toward central bank targets and make rate cuts more likely; bond prices rise along with the hopes, sending yields down. When the news of the day points to a stronger economy, investors assume that inflation will take longer to fall and therefore rate cuts fade into the distance; bond prices fade with them, sending yields sharply higher. 

So far this year, government bond yields have seesawed in ranges higher than any time since the Global Financial Crisis and the European Sovereign Debt Crisis. So the worried crowd are definitely in the driving seat. Yet if interest rates stay this high for too long, then this could lead to ‘policy error’ and recessions. Do you see the circular doom loop we are stuck in?

Volatility is high, yet sometimes stats lie 

Since last summer, we have believed that rates have peaked in the US, UK and Europe and that inflation will not drop to 2% as quickly as generally predicted – as you will have heard if you are a regular listener to our podcast The Sharpe End. As such, we feel vindicated by current events. However, it has been a stressful ride as the market has flipped from anticipating many rate cuts to none, and at some points even rises were predicted. 

This flip-flopping market sentiment has been very unhelpful for us in two key ways: 

1. Bonds’ relative volatility to equities has risen markedly – we hold a little over 21% in government bonds (by far our highest position since inception) in our medium-risk fund, Rathbone Multi-Asset Strategic Growth Portfolio, with 8 years’ duration. These holdings have been incredibly volatile and correlated with equities so have not acted as diversifiers. In fact, they have added to our volatility, which means we are currently above our three-year volatility targets relative to global equities across our fund range.

If we were a ‘black box’ quant fund we would be forced to sell our government bond holdings to reduce our volatility. Fortunately we are not, so we have been adding to our positions throughout April to back our conviction, but diversifying into new countries in Europe, namely Germany, Portugal and Romania. Because European interest rates are so much lower than in the UK, we get paid to hedge these investments to sterling at the moment (that means an all-in yield of roughly 6.5% for our Romanian bonds, for example).

2. Increased relative volatility to peers – given we have held fast to our high-conviction view on peak rates, our funds tend to go to the bottom of our peer group when bond yields rise and then go to the top when they fall, often within a week. This is as at odds with our normal smoother trajectory.

While this increased volatility is unwelcome, we’re unwilling to compromise our strategy due to a short-term statistical anomaly. Sometimes it’s important to hold tight when the noise is excruciatingly loud, as it is currently, even if it feels uncomfortable. We firmly believe Government bonds will rally very hard once inflation rates return to their falling trends, even if they don’t quite reach 2% for a while (which we think is quite likely). Even with 2.5% inflation, say, real yields of 2%+ would be really attractive on an historic basis. And we could see roughly 25% capital gains from the long-duration bonds in our portfolios in a relatively short period of time if prevailing yields fall by one percentage point. Yes, equity-like returns from govvies. 

If the worst happens and rates stay too high for too long, resulting in recessions or no growth then, again, we could see government bonds rally in anticipation of emergency rate cuts. Equites won’t look great in this scenario (anticipating falling earnings) but bonds could make big double-digit gains and – more importantly – resume their negative correlation to equities and their roles as diversifiers.

Although our volatility compared with stock markets is high, our actual volatility is still in single-digit territory, so relatively low in a long-term context. You need to be careful about statistics sometimes and focus on the real world. Sometimes too much colour can be distracting, much better to narrow the focus on the performance.

Tune in to The Sharpe End - a multi-asset investing podcast from Rathbones. You can listen here or whenever you get your podcasts. New episodes monthly.