Beware Duration

Gilts - lower returns mean higher risk

A strange thing happened in the UK bond market this week.  It went down – a bit.  It has been an incredible run from the early 1980s when the Gilt yield was almost 16% to a level of 0.71% last week.  Of course it hasn’t been a straight line from high to low but if an investor had been disciplined enough to hold a 10 year Gilt and re-invest the coupons over those 34 years the annualised return would have been over 10% p.a.  Who needs equities?  Not only was the return pretty good but the volatility associated with investing in the Gilt market was lower than that in equity markets, so on a risk adjusted basis, the returns have been excellent.

But here is the problem.  Investing in Government bonds is now a totally different game to 34 years ago.  Investors no longer invest for income – there isn’t much to go for.  The motivation for investors to buy Gilts is now about capturing duration exposure which will deliver capital appreciation if yields keep going down.  Many investors are mandated to buy duration either to match liabilities or match a benchmark, even in markets where yields have turned negative.  It is not difficult to find bonds with negative yields in the funds of so called active and strategic investors.  They are presumably buying because they think the price is going up which means they think the yield is going even more negative.  A brave call, perhaps.

During that 34 year rally in the Gilt market, there were many up and downs but one of the attractive features of bonds is that when you suffer a capital loss, the income accumulates over time and rebuilds the return, so you don’t suffer a drawdown for too long.  You rarely suffered a loss for more than 6 months prior to 1994, when Greenspan famously shocked the markets with a US interest rate rise and Gilts were in loss for almost 2 years.  There was another extended period of losses in the run up to the dot com bubble in 2000.  While tech stocks were booming, Gilts were in loss for about 18 months.  In 2004 we had another bout of nerves in bond markets as the next US rate hike cycle kicked off again but that was only for a year.  But the common thing about all these drawdowns was that income levels were much higher than they are today (7% in 1994, 5% in 2000, 5% in 2004).  So investors just had to wait long enough to rebuild their capital.  More recently we had the taper tantrum in 2014 when the markets again fretted about the end of QE in the US.  Even then, yields were around 3%.  But today, with yields less than 1% in the 10 year Gilt, investors will have to be extraordinarily long term investors.  If the Gilt yield were to rise from 0.75% to 1.75% then the capital loss would be about 6% which means an investor would have to wait 8 years to rebuild capital.  This is a multiple of previous periods of drawdown.  Our judgement is that investors are not that patient. 

When this cycle comes to an end, which it inevitably will, we are likely to see a long period of suffering of investors of all varieties including those that are completely unaware of the maths of bonds and actually how risky they have become.  Some investors have identified the risks and that explains why long dated Gilts have recently become more volatile than global equities.  In a long dated Gilt, even though the starting yield is higher, for a 1% upward move in yields the capital loss is as much as 4 times greater and the period of recovery much longer.

The maths is frightening especially when you consider that a 1% move in yield is not that much – it only takes us back to where we are at the beginning of 2016.  If there were any kind of reversion to mean or normalisation, the shift in yield would be at least 2-3% and with that would come a multiple of potential losses and recovery periods.  For those investors that are still under the misapprehension that Gilts are safe, please beware.  The danger, however, does not only sit within Government bonds.  Many other asset classes such as property, so-called defensive equities and many growth stocks have ridden the crest of the duration wave and would likely significantly underperform in any kind of normalisation shift.

Bonds are in a bubble which means they will probably continue to go up for much longer than anyone thought possible.  No question, we are all concerned about the threat of deflation, there are multiple macro risks in the world, demographic headwinds and too much debt in the wrong places but perhaps investors should now start focussing on a different type of deflation - the potential deflation in the value of their bonds if yields rise.

By Jeff Keen

All market data sourced from Thomson Datastream as at 12.07.16

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