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Our views 19 April 2021

JP’s Journal: Real yields matter

5 min read

What is the most important number in the world right now? Purely from an investment viewpoint I think the answer is somewhere between zero and -0.25%, or the level of long-dated US real yields.

Equity, bond and property prices have been buoyed by the collapse in real yields. If we look at the 2041 Treasury Inflation Protected Security (TIPS), the real yield on issue in 2011 was just over 2%; this fell to below 1% in 2012, giving rise to a capital return of over 50%. The real yield subsequently rose in 2013 and probably averaged about 1% in the period to 2013-2018. At the end of 2020 the rate had fallen to -0.5%.

The UK is even more stark. I sometimes get asked why the coupon on the index linked 2030 bond is 4.125% when surrounding bonds have much lower coupons. The answer is that the bond was issued in 1992 when long-dated real yields in the UK were above 4%. Today, a 30-year index linked gilt would be issued with a real yield of -2%. That means that longer-dated real yields have fallen by six percentage points in 30 years. This is unprecedented and does not get the attention it deserves. This valuation shift, a broadly global event, has crushed nominal bond yields and driven equity yields lower. If you want an explanation of house price inflation don’t blame lack of supply brought about by NIMBYs, planning regulations and greedy house builders – look at the collapse in real yields as the true cause.

So where will real yields go from here and what happens to bond markets? I think they rise, slowly but gradually. Why? Three reasons – demographics, bond supply and over-valuation – basically investors will look for alternative investments as the euphoria of strong annual returns dissipates. This means that returns from bond markets will not be great in the medium term, but it also implies that equity and property markets will be impacted.

There is a self-correcting mechanism which means that too quick a rise in yields will hurt asset valuations, thereby creating a demand for safe havens like TIPS and index linked gilts. However, when looked at through a three hundred-year prism it is hard not to conclude that real yields are at an extreme never previously encountered and that probabilities favour a long-term rise from present levels.

Let’s look an at example: 0.125% 2068 index linked gilt, issued in 2013.

  • If real yields were to rise (less negative) from the current level of -2% to -1% the bond price would fall from 271 to 168.
  • Broadly speaking, if inflation averages 2% (Bank of England’s target) over the next 47 years you will be repaid at around 300 i.e. just 10% above today’s price and below the level seen in the middle of last year.

Cash, government bonds and currencies

Cash rates were little changed over the week drifted lower for choice over the week and sterling was steady against the euro and firmed against the US dollar.

Headline US retail sales in March were strong, up 9.8% against a consensus 5.8%. That now takes the level of retail sales well above pre-crisis levels. Easing social distancing restrictions and fiscal stimulus will both be playing a role in strong retail sales e.g. restaurant sales increased sharply, up 13.4%. Conversely, the bounce in industrial production was less than expected and initial jobless claims were lower than expected. My colleague Melanie Baker feels that the labour market remains the prime focus for the Fed and that whilst strong sales data may feed the narrative that the US risks over-stimulating, unemployment remains materially higher than pre-Covid levels.

Ten-year US government bond yields moved lower to 1.57% with longer dated yields moving broadly in parallel. The euro area remained a relative weak spot with yields moving higher – as an example ten-year French yields almost went positive. In the UK yields were little changed despite extra supply of the 2071 gilt, which cleared at a yield of 1.11%.

The market was surprised by the departure of Andrew Haldane, the Bank of England’s Chief Economist and who is regarded as an optimist on the UK economy. There was initially a feeling that this put back the prospect of rate rises in the UK, with sterling weakening, but the impact was short lived.

Credit

Sterling credit spreads were steady and remained just above the lows for the year. It was a very quiet week for us with few new issues and little that we found attractive. Similarly, there is not much to report of global investment grade this week. High yield spreads held in at recent lows; we got involved in a couple of US private placements, but secondary market activity was limited. I remain bullish on high yield.

We are giving thought to how we position fund strategies as we increase our focus on ESG issues and implement current, and consider future, regulations. I would certainly welcome feedback on what our clients want from us.

In big picture terms there is a clear choice: exclude or engage. It is difficult to get engagement if you are not a stakeholder. I generally favour engagement but there are funds and strategies that we run that follow an exclusion route – for example our Ethical Bond Fund. What is becoming clear is that those issuers which fall foul of various ESG criteria are finding their cost of debt rising. Whether in sectors like tobacco, thermal coal, and armaments or those that display poor governance or have poor working practices – these companies are literally paying a price. I see our job as providing an attractive financial return to our clients in a responsible manner. However, there will increasingly be issuers that become un-investable, not just on ethical or ESG grounds but because the financial rewards are outweighed by risk.

Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are the author’s own and do not constitute investment advice.

The Royal London Ethical Bond Fund is a sub-fund of Royal London Bond Funds II ICVC, an open-ended investment company with variable capital with segregated liability between sub-funds, incorporated in England and Wales under registered number IC001128. The Company is a UCITS umbrella fund. The Authorised Corporate Director (ACD) is Royal London Unit Trust Managers Limited, authorised and regulated by the Financial Conduct Authority, with firm reference number 144037. For more information on the fund or the risks of investing, please refer to the Prospectus or Key Investor Information Document (KIID), available via the relevant Fund Information page on www.rlam.co.uk