The bond bust bodes well for equities

Rising yields on government debt herald the end of the free-money era and good news for investors.

A recent survey of professional pension trustees of UK defined-benefit pension schemes, from Charles Stanley Fiduciary Management, revealed that 82% of trustees believed that they had the knowledge and skills needed to handle the “liability-driven investment” (LDI) crisis. Moreover, 72% of trustees were confident in using LDI as a tool to manage risk and 78% thought their scheme had the right governance in place to handle the LDI crisis. This is laughable.

In response to the greatest investment bubble of all time – which saw the yield on government bonds falling to levels that, according to research by Bank of America, were the lowest for 5,000 years – these trustees saw fit not only to load their funds up to the gunwales with government bonds but also to speculate on further falls in yields using derivatives.

The roots of the LDI crisis
When bond yields started to rise, the losses mounted, leading to the LDI crisis. Pension funds were forced to close out their speculative positions by selling bonds in a falling market to cover their margin calls. This resulted in a market panic, which drove ten-year gilt yields over 4% and sterling towards parity with the dollar.

The crisis has been widely blamed on Liz Truss’s mini-budget. But the fact that bond yields have been rising across the developed world (with ten-year gilt yields recently reaching 4.6% and ten-year US Treasury yields 4.8%), even though inflationary pressures have abated, shows that this is nonsense. The truth is that the trustees were caught in a wholly predictable market crash, which has lost the pension funds, for which they are responsible, hundreds of billions of pounds.

Since March 2000, ten-year US Treasuries have lost 46% of their value (in nominal terms) and 30-year bonds 53%. The bear market may now enjoy a respite, but it is probably not over. As investment strategist Ed Yardeni of Yardeni Research points out, the supply of bonds has increased thanks to the extravagance of governments. Meanwhile, demand has decreased as banks have stopped raising their holdings and central banks are selling (at a loss, inevitably) – in a reversal of quantitative easing. “The question is whether the [rise] in yields is enough to attract enough demand,” he writes. The answer is probably not, despite the urgings of investment advisers – who never saw the crash coming because they were far too busy being bearish about stockmarkets – to load up. Once bitten, twice shy, as the saying goes. 

Bond yields have been below inflation for years and although they are now above it in the US, real yields of 1.5% are not tempting. In the UK, real yields are still negative. What Yardeni calls the “bond vigilantes” still aren’t happy, and they are likely to determine the fiscal policy of governments. That means making borrowing much more expensive, with real yields rising to 3% and governments slamming the brakes on spending. At present, they are only cutting back on planned increases. The age of austerity beckons and with the vigilantes in control, a lot of innocent bystanders will get shot.

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Max King
Investment Writer

Max has an Economics degree from the University of Cambridge and is a chartered accountant. He worked at Investec Asset Management for 12 years, managing multi-asset funds investing in internally and externally managed funds, including investment trusts. This included a fund of investment trusts which grew to £120m+. Max has managed ten investment trusts (winning many awards) and sat on the boards of three trusts – two directorships are still active.

After 39 years in financial services, including 30 as a professional fund manager, Max took semi-retirement in 2017. Max has been a MoneyWeek columnist since 2016 writing about investment funds and more generally on markets online, plus occasional opinion pieces. He also writes for the Investment Trust Handbook each year and has contributed to The Daily Telegraph and other publications. See here for details of current investments held by Max.