Why bonds lack investment appeal as inflation fears mount

High inflation means that real returns across fixed-income securities are deeply in the red. Worse still, real returns could further deteriorate if, as expected, the rate of inflation continues to rise over the coming months. Indeed, the Bank of England forecasts that inflation will increase to around 11% in the latter part of the current year.

Even as the ‘Old Lady of Threadneedle Street’ adopts a more hawkish monetary policy, which centres on rising interest rates, time lags mean that it may take a number of months for them to fully impact on the rate of inflation. And, with the ongoing war in Ukraine prompting higher energy prices, the current period of high inflation may prove to be more persistent than previously anticipated.

Rising interest rates

Of course, the Bank of England’s decision to raise interest rates at each of its past five meetings means that bond prices have recently come under severe pressure. Since Bank rate is forecast to reach almost 3% by the end of the year in response to a further increase in the rate of inflation, the near-term outlook for bond prices is highly downbeat. Their inverse relationship with interest rates means that it is difficult to forecast price rises while policymakers are seemingly intent on seeking to curb extreme levels of inflation via a tighter monetary policy.

This situation is arguably made worse by the extremely loose monetary policy actions followed since the global financial crisis. Ultra-low interest rates that were further reduced in response to the pandemic mean that many bonds are priced at exceptionally high levels that indicate they offer poor value for money – especially when the prospect of high inflation and rapidly rising interest rates are taken into account.

For example, the benchmark 10-year gilt yield has surged higher over recent months. At the start of the year it was around 1%. Currently, it stands at around 2.5%. Although this represents a large rise in a short space of time, today’s yield is not high by historical standards. Indeed, it could easily be argued that it continues to lack appeal in an era where inflation is set to rise so that it reaches more than five times the Bank of England’s 2% target.

Economic challenges

A high rate of inflation is also set to cause a cost-of-living crisis, since wage growth seems unlikely to keep pace with the current rapidly rising price level. When combined with rising interest rates that dissuade investment and reduce overall spending, this is expected to prompt a sharp slowdown in economic growth. Indeed, the IMF expects the UK economy’s 7.4% growth rate from 2021 to slow to 3.7% in 2022. It then forecasts a rise in GDP of just 1.2% in 2023.

A slower rate of economic growth could prompt the Bank of England to pursue a less hawkish monetary policy. It may feel that rapid interest rate rises are less appropriate due to an increasingly uncertain, and challenging, economic outlook. The emergence of such a scenario could offer some support to bond prices, although a cut in interest rates would be difficult to justify in an era of high inflation – even if the economy’s outlook rapidly deteriorates over the coming months.

Interest rate sensitivity

Of course, the impact of an evolving economic outlook and changing monetary policy on the fixed-income market may be somewhat nuanced. For example, interest rate rises may have a disproportionately negative impact on gilts vis-à-vis corporate bonds.

Gilt prices may be affected to a greater extent by monetary policy tightening because they tend to be longer dated than corporate bonds. Since they have a larger number of future cash flows attached to them, they are more sensitive to interest rate changes. Therefore, they may experience greater price falls than corporate bonds during a more constrained monetary policy environment that includes a series of interest rate rises over the coming months.

A safer option

Conversely, gilts may fare better than corporate bonds if, as expected, the economy’s growth rate comes under pressure due to the impact of high inflation and rising interest rates. Corporate bond issuers are, in most cases, reliant on the macroeconomic outlook because it impacts on their operating environment.

Lower sales and reduced profits could impair their capacity to service debt and make repayments. This could mean that default rates rise and investor demand for corporate bonds declines. Since gilts carry extremely low credit risk, unlike corporate bonds, they may become relatively attractive should the economy’s prospects further deteriorate following recent downgrades to growth expectations.

High yield risks

Within the corporate bond segment, high yield bonds could suffer to a greater extent than investment grade securities from a worsening economic outlook due to the weaker financial positions of their issuers. They may be less likely to successfully overcome a period of lower demand for their goods and services, which could affect their ability to service debt and make repayments.

Although higher quality issuers are not immune from such threats, their investment grade status suggests they have a greater chance of meeting their debt obligations. As ever, high yield bonds offer greater return potential than investment grade securities. But they come with greater risk of default that may become increasingly undesirable among investors as the full effects of high inflation and rising interest rates are felt on the performance of the UK, and global, economy.

A prudent strategy

Due to the highly uncertain outlook for inflation, interest rates and economic growth, investors may wish to avoid focusing on a specific area of the fixed-income market. For example, exclusively holding gilts may mean they are more exposed to the effect of interest rate rises on bond prices due to the generally longer dated nature of gilts compared to corporate bonds. Conversely, solely owning high yield bonds may leave investors susceptible to the negative impact of a slowing economy as interest rates rise.

Therefore, an approach that includes different areas of the fixed-income market could prove to be logical. For instance, this could mean holding a strategic bond fund that is able to invest in a range of issuers, from gilts through to high yield, and which owns a variety of short, medium and long-dated issues. Although this strategy may fail to offset the ill effects of high, and rising, inflation and a tighter monetary policy on bond prices and their returns, it could provide diversification benefits while the prospects for fixed-income securities remain highly uncertain.

A downbeat future

Clearly, forecasts regarding inflation, interest rates and economic growth have their limitations and are subject to change over time. Indeed, few investors would have predicted a 40-year high for inflation, an interest rate of 1.25% and a rapidly slowing growth rate for the UK economy just a matter of months ago. As a result, the current bearish outlook for fixed-income securities may prove to be inaccurate.

Still, after over a decade of ultra-loose monetary policy and benign inflation, the prospects for bondholders have become increasingly uncertain and downbeat. Although holding a diverse range of bond funds may alleviate some risk, the prospect of generating a positive real return, or even a modest negative real return, seem somewhat distant.

As a result, investors should ensure they are not reliant on bonds for their returns over the coming years. They may even wish to focus on other assets, such as equities, when allocating capital on a long-term view.

See also: Bonds, Pensions and IHT – It’s complicated

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