Inflation is rising, central banks are removing monetary stimulus, and 10-year US Treasury (UST) yields are increasing. This may sound familiar, but this isn’t today, but September 1981, when the 10-year US Treasury yield was almost 15.9%1, the Consumer Price Index (CPI) was 10.1%2 year-on-year and the federal funds rate was 15.50%3. Since September 1981, bond yields have drifted lower and lower, dropping to a low of around 0.5%4 in early April 2020. Today, at the time of writing, the 10-year UST yield is 2.40%5, CPI is 7.9%6, and the federal funds rate is 0.50%7. When confronted with rising inflation and less accommodative monetary policy from central banks, the current outlook for bonds is challenging.
The current building blocks of our bond portfolio
At The People’s Pension, our bond portfolio has 3 different building blocks:
- Sterling corporate bonds
- Global bonds
This portfolio has benefitted from 3 coinciding tailwinds:
- Falling interest rates (bond prices rise as interest rates fall), which has been of greatest benefit to the longer-dated gilts held in our portfolios.
- Narrowing credit spreads (corporate bond values tend to increase as spreads narrow), which has helped the sterling corporate bonds’ allocation, especially those with longer maturity dates.
- The general performance of sterling debt, which over the past decade has been among the best performers in the investment grade universe (ie assets regarded as carrying a minimal risk of default to investors) and represents a significant portion of our bond allocation.
Due to current market trends, we think now is the right time to collect the profits from our current bond portfolio and review our strategies to enable us to plan an appropriate progressive structure for our portfolio’s fixed income proportion.
This is also of primary importance when building a multi-asset portfolio, one that is suitably diversified so it can withstand unfavourable movements in asset prices without sacrificing too much in the way of returns. Holding uncorrelated assets (ie assets that are unrelated and move up or down in the opposite direction to each other) helps us to build more resilient portfolios for our members, as it lowers performance dispersion with the aim of providing more predictable returns. This doesn’t completely remove the effects of market turbulence but alleviates them to some degree.
Our 5 reasons for investing in USTs
We think it’s appropriate to start adding USTs now, funded by the sale of gilts and sterling corporate bonds, for 5 reasons:
- They can diversify our multi-asset portfolios – as they have less correlation with the equity components compared to our current bond allocation.
- They provide a ‘left-tail’ risk hedge, ie a buffer when risk assets fall or when investor sentiment turns negative.
- Due to its shorter duration, an all-maturity UST index is less sensitive to rate increases than gilts. An all-maturity gilts index contains bonds which mature in 30, 40, and 50-years’ time, whereas in the US, the longest-dated bond matures in around 30 years. In a rising rate environment, these longer bonds tend to suffer, hurting portfolio performance. The same is true of sterling corporate bonds, which in addition to having several long-dated issues within the index, also have narrow spreads over gilts.
- We think that rising interest rates carry a risk of either a policy mistake or a derating of some of the growth mega caps that have been driving performance in the pre-eminent equity market of the last decade – the US. Any fall in the value of equities could trigger widening credit spreads, which, all other things being equal, would likely cause corporate bonds to fall.
- USTs have the highest quality credit rating from the rating agencies (AAA) and therefore carry a less risk of a damaging default.
In summary, we think that adding USTs makes the portfolio more robust in the event of a negative market environment.
As a result, USTs should help our members’ portfolio performance over the long term. Four different economic regimes are possible over the next 12 to 18 months, of which the first 2 are most likely:
1) Slowing growth, rising inflation, and a neutral monetary policy
2) Accelerating growth, rising inflation, and a hawkish monetary policy
3) Weakening growth and inflation, and a dovish monetary policy
4) Accelerating growth, slowing inflation, and a neutral monetary policy
We think that increasing our portfolio’s exposure to USTs at the expense of gilts and sterling corporate bonds will pay off in regimes 1 and 2 and help to add value to our members’ savings.
- Bloomberg (Data as at 30/09/1981)
- US Bureau of Labor Statistic, YoY, not seasonally adjusted (Data for September 1981, published in October 1981)
- US Federal Reserve (Data as at 30/09/1981)
- Bloomberg (Data for April 2020)
- Bloomberg (Data for April 2020
- US Bureau of Labor Statistic, YoY, not seasonally adjusted (Data for February 2022, published in March 2022)
- US Federal Reserve (Data as at 16/03/2022)
This article was written when we were B&CE, before we changed our name to People’s Partnership in November 2022.