Morning Note: Market news and our thoughts on UK Bonds

Market News

US January non-farm payrolls came in well above market expectations, 353K vs. 185K forecast. The unemployment rate was 3.7%, in line with the 3.8% forecast. Hourly earnings were up 4.5%, faster than the 4.1% expected. The data dashed expectations of rate cuts soon. In addition, Chair Jerome Powell said the Fed will probably wait beyond March to cut rates, with policymakers needing more data to be sure inflation is on a path to their 2% goal. The “danger of moving too soon is that the job’s not quite done,” he told CBS’s 60 Minutes. The dollar rose, the 10-year Treasury yield went back over 4%, and gold slipped to $2,030 an ounce.

This morning in Asia, markets were mixed: Nikkei 225 (+0.5%); Hang Seng (-0.1%); Shanghai Composite (-1.0%). This was despite the Chinese securities regulator said it will take effective measures to prevent stock pledging risks. US equity markets are predicted to be up a touch at the open this afternoon. The FTSE 100 is currently trading 0.3% higher at 7,641, which Sterling buys at $1.2616 and €1.1705.

Brent slipped to $77.50 a barrel despite ongoing heighted geopolitical tension in the Middle East. The global oil market is looking increasingly local as attacks in the Red Sea and surging freight rates make supplies from closer to home more attractive. Buyers in Europe are snapping up North Sea and Guyana cargoes. Donald Trump suggested he’d impose a tariff on Chinese goods of more than 60% if elected, signalling an increasingly hawkish tone on Beijing.

Emerging market corporate bonds denominated in US dollars are yielding higher returns than most other asset classes in the EM universe so far this year, up an annualised 12%. Prices are jumping due to a dearth of EM corporate bonds in secondary trading and the EM bonds are outperforming US corporate notes, narrowing the yield spread to the lowest since June 2021.

Source: Bloomberg

UK Bond View – Gilty Secrets

Everyone, through their recent lived experience, understands the significant uplift in prices we have seen in recent years driven the double whammy of the pandemic (and subsequent policy response) and the war in Ukraine (and the consequent energy shock).  However, the impact on returns for cash and cash-like investments is often under appreciated.  Below, we walk you through the return of two UK government bonds (gilts), one nominal and one index-linked that are both approaching redemption, starting at the beginning of 2019, in both nominal and real returns.

The specific gilts used are: UK Gilt 1% 22/4/24 and UK Inflation-Linked Gilt 0.125% 22/3/24

These have been selected as they have almost the same maturity and have very low coupons.  Hence the numbers quoted below are approximations based on price return (rather than total return including coupon payments) that are broadly comparable to illustrate the point, rather than exact calculations.

First the nominal gilt.  The chart below shows the yield on this gilt from 01/01/19 was 1%.  In the years that followed, inflation jumped and yields rose to around 5%, as the Bank of England increased the base rate and the gilt approached maturity.

UK Gilt 1% 22/4/24 YTM

Source: Bloomberg

The chart below shows the price return, where the gilt started at around 100, fell as short-term rates rose, and is now virtually back to 100 as it approaches maturity.  The 1% annual yield all came from the coupon but despite all the price swings, the Gilt delivered the 1% return it mathematically had to when purchased.

UK Nominal Gilt Price Return 2019 - 2024

Source Bloomberg

However, over the period with the high rates of inflation, the price level increased around 33% based upon the RPI. 

UK RPI (Indexed to 100 at 01/01/2019)

Source: Bloomberg.

Hence in real terms this nominal gilt lost around 21% over the period.  The chart below shows the price return to which we add 5% as an approximation for the coupons over the period.  Not great for a “risk free” investment.

UK Nominal Gilt Real Price Return 2019 - 2024

Source: Bloomberg

Moving to the index-linked bond, looking back to January 2019 the real yield on this bond was a very unappealing -2.2%.  This was a reflection of the deeply negative real yields that persisted all across the UK index-linked curve. 

UK Inflation-Linked Gilt 0.125% 22/3/24 Real Yield 2019 - 2024

Source; Bloomberg

Buying this bond meant that you were guaranteed to have a return over the period of 12% less than inflation, which is indeed what you got.

UK Inflation-Linked Gilt 0.125% 22/3/24 Real Return 2019 - 2024

Source: Bloomberg

However, because the coupon and principal are uplifted by the RPI, the nominal return on this bond was 17%, handily beating the nominal bond.  This is because the actual realised inflation turned out to be much higher than the breakeven inflation priced into the bonds at the outset of our analysis.

UK Inflation-Linked Gilt 0.125% 22/3/24 Nominal Return 2019 – 2024

Source: Bloomberg

Going through the actual mechanics of what played out during an inflationary shock and working out what that means for nominal and real returns in the risk-free sovereign fixed income markets is a useful exercise when thinking about the future.

Key Takeaways:

• While a 1% nominal return may optically feel better than a -2.2% real return it may not be if inflation comes in higher than is priced into markets.  In the UK, markets see the RPI at between 3% and 3.5% across all tenors, short and long.

• The massive shift higher in the curve we have seen in the last two years means that prospective returns from gilts are materially better as shown in the chart below.

UK Index Linked Curves 26/1/2024 (green) and 1/1/2019 (Yellow)

Source: Bloomberg

• Long duration indexed linked bonds can be exceptionally volatile, however with +1.4% real yields over 20-30 years, these assets can provide a great anchor to portfolios.  Many factors affect the level of real yields, and they can certainly go higher, however there is a level at which they become more attractive than almost all other assets on a risk adjusted basis.  Investors should have some exposure and add on any material price weakness.

• They are an excellent hedge should the events of the early 2020s prove not to be a transitory episode in history.