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Articles by Duncan

Duncan MacInnes

Fund Manager

16 November 2023

This month’s chart shows a profound change in the investing landscape. Just two years ago, if a saver wished to teleport $1,000 of purchasing power 30 years into the future, at the low of -0.5% real yields, it was necessary to set aside a staggering $1,190. Life has recently become easier: with real yields much improved at 2.3%, the same goal can be achieved by setting aside just $490.

This hasn’t gone unnoticed. Investors have been buying bonds at a fair clip in recent weeks, and prices have already moved since the Ruffer portfolio took a 10% position in US ten year TIPS last month.

So is this the beginning of the end of the precipitous bear market in bonds?

Last year, the aggregate US fixed income market notched up its worst year since 1871, and US Treasuries are on track for three consecutive years of negative returns – something that has never happened before. Everyone now knows bonds have been terrible.

Why? The story goes: there’s a buyer’s strike, western governments are bust, the bond vigilantes are back etc. Surveying the wreckage, the long US government bond ETF (TLT) is down more than 50% from its 2020 high.

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Today, investors can lend to the US government for a guaranteed 2.3% real return. They will earn 2.3% plus inflation, whatever that might be, every year, for the full term, if held to maturity. This becomes a challenging hurdle for every other risk asset in portfolios to measure up against. A certain return in an uncertain world – a valid long-term case for owning inflation-linked bonds.

But that is the worst-case scenario. A short-term, cyclical rationale extends to both inflation-linked and conventional bonds. And it is arguably a more compelling case altogether.
Our base case is the economy and markets are too leveraged and too financialised to cope with 5% nominal rates and real rates over 2% for an extended period.

In this scenario, the global economy enters a recession or market crisis in which some combination of rate cuts and a flight to safe havens pushes bond yields down, lifting the capital values mechanically. A 2% fall in interest rates could generate a total return of more than 20% for 10 year bonds. Investors can sell these bonds and rotate into bombed out risk assets – thus setting up their expected returns for the next period.

A less well known, and even less well understood feature of bonds, is convexity. Convexity in practice means that from current yields, the price benefit from rates falling is significantly greater than the pain from rates rising. Heads you win, tails you don’t lose as much.

Lastly, from a portfolio perspective, how long can equities continue to ignore rising rates?

The rise in yields may have sown the seeds of its own destruction – the long and variable lags of monetary policy are still taking effect. Signs are increasingly visible that high interest rates are causing damage in financial markets (struggling small caps and banks, private equity and venture capital drying up) and now also in the real economy (higher corporate delinquencies, falling job openings and sky high mortgage rates). Any path involving yet higher bond yields most likely involves pain for markets in areas we have protection.

#inflation-linked bonds

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