Inflation and Rising Bond Yields: Time to Rebalance your Portfolio?

Investment management consultant MATTHEW FEARGRIEVE discusses the market dynamics driving rising bond yields, and considers the implications of an inflationary environment on your portfolio investments.

The prospect of inflation, and rising yields on government bonds, are uppermost in investors' minds right now. All eyes this week will be on the interest rate-setting meetings of the Federal Reserve in the US, the Bank of England and the Bank of Japan.


As we write, the Federal Open Market Committee (FOMC) has concluded its March 16-17 policy meeting. The Fed's main objective has been to convince consumers and financial markets that a post-pandemic economic recovery is not guaranteed, and that interest rates in the US are to stay on the floor, which is where they have been since the start of the pandemic. Indeed, the Fed indicates that it isn’t expecting a rate increase until 2023 at the earliest.


Inflation and why it matters


The rate of inflation in the US is still well sort of the Fed’s indicated rate of 2%. But there is a real and growing concern that global stimulus packages, coupled with the pent-up demand from locked-down consumers, could hike up the cost of living significantly, which will precipitate a period of price inflation.


And now the Fed sees inflation running to 2.4% this year, ahead of its previous estimate of 1.8%.


Inflation and the impact on Government Bonds


Government-issued bonds are a barometer of inflation. Bonds are the financial asset most sensitive to inflation. This is because the present-day value of the future interest and capital repayments of government bonds are directly influenced by inflation. Reduced returns make bonds less attractive to investors. Hence the strife in the bond markets of late.


In the first part of this three-part article, we gave you a top-level summary of the reasons behind rising bond yields and their significance for investors. In this, the second part, we will discuss the impact that an inflationary economic environment will have on your personal investment portfolio.


First, though, we will recap some of the basics of bonds and bond yields, and why the bond markets are the focus of investor attention at the moment.


What are bond yields?


A government bond is basically an IOU, or debt instrument, issued by a government or a country’s central bank (like the Fed in the US and the European Central Bank or ECB in Europe) in return for money. The bond instrument pays the lender (also known as the bond investor or bondholder) a fixed return over a fixed period. So 10-year US Treasuries are bonds that are repayable by the US government over a ten-year period.


The bond yield is essentially the return that a bond delivers.


Why are bond yields rising?


Bond yields are rising because of two things that are currently exercising the financial markets: inflation and fiscal stimulus.


The recently approved US$1.9 trillion stimulus package (with a US$900 billion supplemental coronavirus relief bill on the legislative horizon) approved in the US, and similar boosts provided by the ECB in Europe, are big pieces of fiscal stimulus, which are combining with the unleashing of pent-up consumer demand on the part of hundreds of millions of consumers who have saved money over a year of lockdown.


These two dynamics – government economic initiatives and consumer spending – normally cause price inflation.


Inflation is bad for government bonds. When prices rise at a rate greater than the interest earned on a bond, it follows that the value of the fixed income delivered by the bond will fall. Consider a five-year bond paying 2% nominal interest. If inflation rises to 2.5% for those five years, the income paid by the bond will not be able to keep up.


In this situation, bond investors want some reassurance that the long-term returns on their bonds will not be eroded by inflation over the term (or maturity) of the bond.


Government-led fiscal stimulus is, somewhat paradoxically, also bad for government bonds. When governments pump out debt, the price of bonds falls, whereas the yield, being inversely related to bond prices, rises. A related market phenomenon here is the recent emergence of bond vigilantes, bond investors who want to discourage monetary or fiscal policies by selling bonds in large amounts, thereby increasing bond yields. This in turn makes borrowing more expensive for governments, which acts as a potential disincentive on issuing more debt, the desired goal of the bond vigilantes.


Government and corporate bonds outside the US will broadly align with the US market, which is the biggest bond market in the world. Accordingly, there has been some rise in bond yields in Japan, Europe and the UK, even though these economies have not implemented fiscal stimulus programmes anything like the scale of Biden’s US$1.9 trillion package.


Are rising bond yields a bad thing?


Rising yields in turn depress bond prices, making investment in bonds and government debt less attractive. The combined market forces of inflation and rising yields have caused the market value of bonds to fall, as have the activities of the bond vigilantes.


The rising yields will stick around for as long as inflation is a worry. And an inflationary economic environment favours certain kinds of asset classes.


What are the implications for my portfolio?


When thinking about rising bond yields and the prospect of inflation, it is necessary as usual to consider separately the “bonds” (debt) and the “equities” (stocks and shares) components of your portfolio.


Bonds


Given the uncertainties in the bond markets, you would be forgiven for thinking about moving some of your bond and fixed-income investments into cash, whilst waiting to see where longer-term bond rates end up.


Whilst uncertainties in the bond (and equity) markets might argue in favour of increasing your cash reserve to between 10% to 17% of the overall value of your portfolio, you can are by no means precluded from buying bond funds for your portfolio. Just make sure that you follow these two, protective rules.


First, avoid bonds with longer maturities, say, anything over three to five years. Bonds with longer maturities are more exposed to changes in interest rates, meaning they have more to lose if rates rise (which they invariably do, once inflation kicks in).


Secondly: use inflation-linked bonds (like TIPS) as a way of keeping your money in fixed income whilst protecting against inflation risks. The coupon offered on these bonds is linked to a rate of inflation, meaning the interest they pay rises as inflation goes up.


Equities


Market fears about inflation are already being played out on the US Nasdaq index, which is dominated by high growth tech stocks. The index has fallen by more than 8% in the past two weeks.


Inflation, though, is not necessarily a bad thing for all stocks. Indeed, it has different implications for different types equities. A big consequence of inflation (or the fear thereof) is to drive in the realm of investor sentiment a rotation out of (high-value) growth stocks into (cheaper and more cyclical) value stocks.


Growth stocks were the big winners of 2020: the tech, pharma and stay-at-home retail stocks, which did so well partly because of the low rate, low inflation environment. An inflationary environment threatens that appeal.


And so US mutual funds focused on value stocks enjoyed inflows of US$6.3bn in February, up from US$1.3bn in January. Growth funds, in contrast, saw outflows of US$18bn in January.


Correspondingly, the MSCI global value index has risen nearly 9% so far this year. In 2020r it fell by 3.6%, lagging the MSCI global growth index by 33% as money poured into stocks like Tesla, Peloton and Apple. So far in 2021, in contrast, it is the likes of ExxonMobil, Caterpillar and Wells Fargo that are doing better.


Gold, property, commodities, infrastructure and smaller companies are sectors that are set to do better than they did over the pandemic. The kinds of stocks which have benefited so much from the a low-rate, low-inflation environment that we have had for some time – the prime example being Big Tech- are now expected to perform less well than they did in 2020.


Sectors like materials, commodities, consumer goods and industrials are all expected to start to do better as global economies start to pick up speed.


Commodities historically outperform when inflation kicks in. Their relationship is not clear cut though. Rising commodity prices tend to be both a cause and a reflection of inflation. Commodity producers often raise their prices in line with inflation because their cost of production goes up, in turn exacerbating those rises.


Separately, asset classes like property and infrastructure often do well in times of inflation. Infrastructure assets have explicit linkage to inflation, and the relationship of infrastructure to property is instructive: as prices rise, so do building costs, and therefore, so do property prices.


Lastly, many investors will have their eye on gold. Many of us will have bought some exposure to gold miners and gold producers for our portfolios at the start of the pandemic, given that gold is the traditional flight-to-safety asset when equity markets are turbulent. When inflation is driven by rising commodity prices, gold tends to do well.


So what should I do with my portfolio?


In the third part of this three-part article, you can read my suggestions for bond- and equity- mutual funds that would provide your portfolio with some protection against rising yields on government bonds and the prospect of price inflation.


What else?


To understand more about bonds, bond yields and why they are rising, click here for Part 1.


MATTHEW FEARGRIEVE is an investment management consultant. You can read his investing blog here and see his Twitter feed here.


Matthew Feargrieve, investment management consultant

IMPORTANT: this article contains the author's opinions only, and is not intended to be binding investment advice for which you should always consult your own professional financial adviser.


Drop Matthew Feargrieve a Line

at www.feargrieve.co.uk

London, England

© 2020 by Matthew Feargrieve.