The ‘myth’ that fixed income securities are safe investments persists, despite the experience of 2022 and continuing rising real yields through 2023.
Notwithstanding the vastly increased complexity of the bond market in the intervening period, some advisers are no more fixed income-savvy than they were 50 years ago, when index-linked gilts (ILGs) did not exist and the corporate bond market was moribund.
On the surface, a bond’s greater predictability of cashflows can be interpreted as lower risk.
Before inflation took hold in 1973, this was self-evident in the UK. Typically, investors lent to the government of the day, confident the UK would not default on its obligations, in return for a yield on that ‘gilt-edged’ security and the eventual return of £100 in capital, whatever its purchase price.
However, a subsequent 18-month period where inflation rose from 5% to 25%, alongside interest rate rises to 13%, changed everything.
The relatively small UK corporate bond market effectively disappeared as yields on long-term debentures rocketed. Variable interest rates seemed more attractive as businesses looked forward to eventual falling interest rates, while plummeting real profits meant funding high and fixed long-term interest payments merely doubled a risk companies already deemed unattractive. Companies turned to the banks for loans as a consequence.
By 1981, as monetarism became the economic mantra in the inflation-battered West, it was suggested investors (especially pension funds) might be prepared to accept a lower real rate of interest in return for insurance against inflation. Indeed, the innovative issue of ILGs in the UK that year was significantly oversubscribed.
More selfishly, the introduction of ILGs would allow the UK government to achieve its monetary target via interest liabilities at significantly lower rates than would otherwise be necessary (the prevailing bank rate was 16%). So ILGs replaced issues of conventional (higher coupon) gilts.
Those low rates would run for decades, thus establishing ILGs as fundamentally long-term investments.
By the 1990s, lower rates encouraged wider participation in bond markets by industrial companies. From an investor’s viewpoint, economics, politics and currency considerations began to take a backseat, while credit quality became the foremost consideration.
Fund managers now needed to contend with swap spreads and event risk, as well as a more complex interplay between coupon, maturity, price, etc, and market views on inflation and interest rates.
After the UK’s Accounting Standards Board adopted AA corporate bonds as its liability-measuring benchmark, corporates became the mainstay of fund managers’ portfolios along with ILGs’ domination of liability driven investments (LDIs).
However, this multi-decade development (and increased complexity) of fixed income markets has not seen a concomitant rise in advisers’ understanding, which, in turn, has misrepresented clients’ portfolio risk.
This is most clearly seen in the almost ubiquitous use of duration as a measure of bond fund risk.
Duration is the average-weighted amount of time it takes to get your money back on a bond investment. As a secondary feature, a variant of duration also provides an estimate of how a bond’s price might move based on a change in the yield. As a rule of thumb, for every 1% increase or decrease in interest rates, a bond’s price will change approximately 1% in the opposite direction for every year of duration.
But most people do not buy individual bonds, they buy bond funds. At fund level, duration is a gross oversimplification of risk, because not all bonds are the same.
Duration changes as yields change and the relationship is not linear but curved, hence the measure of the sensitivity of a bond’s duration to changes in yield is known as ‘convexity’. Higher coupon bonds have a lower convexity, so counter-intuitively a high yield bond is less risky than lower yield in terms of its response to interest rate changes (though not to credit risk).
Since quantitative easing ended in October last year, real yields on ILGs (i.e. gross yield on the ILG minus the inflation rate) have continued to rise, from a negative 2.5% at the opening of this year to over 1% today.
This is because the Bank of England is increasing issuance dramatically in the 2023-24 fiscal year to fund the UK’s budget deficit, and pension funds are somewhat reluctant buyers given the bad press LDIs received in the wake of former prime minister Liz Truss’s Budget shenanigans.
Since April’s round of aggressive gilt issuance began (and there is a fourfold increase in April’s issuance yet to reach the market), ILG prices have fallen 12% and conventional gilts are down 7%, while high yield is up 1%.
Currently, asset managers seem to bear the responsibility for adviser and investor education, and evidence varying degrees of care.
It’s time the Financial Conduct Authority, alongside trade bodies like the Investment Association, took a leaf from the Securities and Exchange Commission’s (SEC) playbook and introduced an equivalent to its “Office of Investor Education and Advocacy” to provide investors (and their advisers) with unbiased enlightenment on the nature of their investment choices – see this typical SEC bulletin explaining corporate bonds.
Organisations like Proshare champion wider employee share ownership, but again work with the industry to promote the schemes, not educate the shareholders.
At some point, it might be worth the regulator making a concerted effort to ‘walk the walk’ of protecting consumers and stabilising the industry by educating investors to be able to make informed choices, rather than simply modulating the regulated.
Graham Bentley is chief investment officer at Avellemy
