Protect your Portfolio against Rising Bond Yields and Inflation

Investment management consultant MATTHEW FEARGRIEVE explains current developments in the Bond Markets and considers some index-linked bond investments for your personal portfolio.

Government bonds have been a troublesome asset since the start of the year. Bond valuations (and, therefore, investment funds that hold bonds) are currently subject to two market dynamics that are negatively impacting government-issued debt as an attractive investment option right now. We are talking about inflation and fiscal stimulus.


This is the first of a three-part discussion of the bond markets, the reasons for rising yields on government bonds, the role of inflation, the impact of all of this on your personal investment portfolio and what you can do about it.


If you want to skip ahead, click here for Part 2 to find out which asset classes are impacted by rising bond yields and inflation.


And click here for Part 3 to read about some mutual funds and ETFs that could protect your portfolio from inflation.


Inflation


First, inflation. Many commentators now agree that inflation is on the visible horizon. Conditions for an inflationary economic environment look right: fiscal and monetary stimulus packages are on their way, like President Biden’s whopping US$1.9 trillion package, and the European Central Bank (ECB) has similarly reiterated its commitment to providing monetary support to the Eurozone.


Furthermore, these government initiatives are combining with widespread pent-up demand on the part of hundreds of millions of consumers who have saved money over a year of lockdown. These are factors that normally usher in a period of price inflation.


Government bonds are a bit like a canary in a coalmine, detecting any hint of inflation in the air. Bonds are the asset with the most to lose from inflation. The present-day value of the future interest and capital repayments of government bonds are directly influenced by inflation.


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 in real terms. 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 won’t be able to keep up.


Fiscal Stimulus


The markets have been spooked recently by the strong rise in bond yields (the return on a bond), triggered by the roll-out of worldwide stimulus packages, particularly in the US and Europe.


When governments pump out debt, the price of bonds falls, whereas the yield (which is inversely related to price) rises. US and European governments have been spooked by the recent emergence of so-called bond vigilantes, bond investors who want to discourage monetary or fiscal policies by selling bonds in large amounts, thus increasing yields. This in turn makes borrowing more expensive for governments.


The 10-year US Treasury yield was around 0.9% in December 2020. Although this represents a dispiriting rate of return on a ten year investment, the low rate clearly signalled that the markets considered the risk of inflationary erosion on a ten-year debt to be minimal.


Fast-forward to the present: the 10-year US Treasury yield has risen to a whopping 1.6%. This yield is about 2.3% higher than the yield on 10-year Treasury Inflation-Protected Securities, or “TIPS”, compared with a gap of just under 2.0% at the end of last year.


This is significant, given that TIPS have some inflation-linked inbuilt protection against rising prices. The difference demonstrates how investors are worried about the return of inflation; their response is to demand a higher yield today from conventional government bonds than from TIPS, because they believe that the risk of inflation has increased. (Read on for a TIPS idea for your own portfolio).


All bonds are priced by comparison, meaning that 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, the Eurozone and the UK, even though these economies are not announcing big new stimulus measures on top of previously-announced anti-pandemic spending.


The effect of rising bond yields on bond prices


Rising yields in turn depress bond prices, making investment products in this asset class less attractive. These two market forces – looming inflation and rising yields – have caused the market value of bond funds to fall in recent weeks.


As you know, traditional investing wisdom dictates that you should hold higher proportions of bonds in your personal portfolio as you get closer to retirement, based on the premise that bonds are less risky than equities (stocks and shares) and pay a steady income.


That wisdom is being challenged right now, given the difficulties in the bond markets. Nevertheless, bonds can and should feature in the portfolios of most investors, and we will explain precisely how, when we come to suggest some bond funds for your personal investment portfolio (see below).


What will happen next in the Bond Markets?


The short answer is, naturally, that no-one knows. No-one ever knows what will happen next, in any market.


There are fears that a continuing rise in bond yields will trigger a repeat of the 2013 ‘Taper Tantrum’, when the US Federal Reserve’s decision to reduce its Treasury bond purchasing panicked investors and pushed yields higher. The situation was exacerbated by Ben Bernanke’s loose talk about curtailing the quantitative easing policy in place since the 2008 Financial Crisis.


The Fed though has signalled its willingness to control yields, although it is not surprising that US Federal Reserve chair Jay Powell is treading carefully in territory where Bernanke trod heavily. The Fed is still somewhat short of its inflationary target of 2%, as it has been for over a decade, and this is against a backdrop of central banks hoping inflation can reduce the debt incurred throughout the covid lockdowns.


And the Fed has just announced that interest rates are to remain at zero. Importantly, though, the Fed sees inflation running to 2.4% this year, ahead of its previous estimate of 1.8%.


All the same, the US government is continuing its huge spending program, so there is a very large amount of US Treasuries (US government bonds) being issued by the Fed. So there is continuing downward pressure on bond prices and continuing potential for spiking bond yields. Neither of which are good for the bond funds in your portfolio.





Bonds and your Portfolio


Bond investors can take some comfort that we have still some way to go before inflation gets anywhere near the 2.4% indicated by the Fed. So should you have bonds and bond funds in your portfolio?


Given the uncertainties in the bond markets, many investors will prefer to move some of their debt investments into cash, whilst we wait to see where longer-term bond rates end up.

You can still buy bond funds for your portfolio, though; just make sure that you follow the following protective guidelines.


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.


Remember though, that if inflation starts to rise too fast, rising yields on traditional government bonds will put a strain on inflation-indexed bonds. Holders of price-linked bonds will benefit from some protection from income and capital repayments against inflation, while rising underlying interest rates will put downward pressure on investment. As bond prices fall, cash becomes more attractive as a haven.


Thirdly: avoid regular bonds from developed countries, in order to protect your portfolio from the potential losses of rising interest rates and inflation concerns; there may be more price declines before the Federal Reserve Board decides to step in to curtail the rising yields.


Fourthly: don't be shy about embracing equities, even if this means changing the bond/equity (or debt/equity or bonds/shares) split that you typically adopt for your portfolio. Most portfolios have done very well with growth equities over 2020, and this momentum is so far holding up pretty well in 2021.


Equities and your Portfolio


A recent report by Bank of America Merrill Lynch showed that a record number of fund managers are overweight on equities - meaning they hold more equities than any other asset class, including bonds.


This bullishness by fund managers reflects the positive expectations they have for corporate results, the buoyancy of the markets and the global economic recovery. These favourable investing conditions are ideal for stocks and shares, less so for bonds.


Accordingly, you should ensure your portfolio is positioned to benefit from widely-held expectations for a good global recovery, and better profits and dividends scheduled for later this year. To achieve this, you need exposure to equities.


Remember, there are still concerns about how long the Fed can sustain its monetary easing policy, and as we (hopefully) start to see evidence of a recovery over April/May/June, worries will intensify about how long the US hyperstimulus can last, which in turn will put more pressure on bonds.


We therefore suggest that you should plan right now for your portfolio to have an equity-oriented strategy for the foreseeable future.


For more about the kinds of equity funds that are appropriate for where we are right now in the post-pandemic recovery, see our article Time to Inflation-proof your Portfolio.


Some Bond Funds to consider for your Portfolio


Bearing in mind the protective guidelines we set out above, you now need to adjust your portfolio's exposure to government bonds. What follows are some low cost, exchange traded funds (ETFs) that provide index-linked exposure to government debt in return for an acceptably-low annual charge (which, as far as this commentator is concerned, is anything under 0.6 per cent per annum). Please note that these ETFs are ideas only, not recommendations or formal investment advice.


The iShares USD TIPS 0-5 UCITS ETF (GBP Hedged) combines both protections, by investing in index-linked US Treasury Bonds with short maturities (0-5 years). With a respectable performance history, a low buy price (around £5 per unit at time of writing) and an annual charge of 0.12%, this product allows you to include bonds in your portfolio and hedge against possible losses due to inflation.


So far this year, investors have lost 7% on US 10-year Treasuries. Holding some short-term US inflation-indexed government bonds is sensible. Avoid longer-term government bonds, which are more exposed to inflation over time.


A suitable bedfellow for this fund could be the Lyxor Core UK Government Inflation Linked Bond UCITS ETF, providing access to UK government bonds (or "gilts") with inbuilt index-linked protection against inflation, for an OCF of just 0.07% (= upside) and a high buy price of around £20 (= downside). The fund tracks the FTSE Actuaries UK Index Linked Gilt All Stocks Index.


An alternative to this Lyxor fund is the L&G All Stocks Index-Linked Gilt Index Trust, a UK unit trust (UCITS compliant) managed by Legal & General that provides index-linked exposure to UK government debt for an acceptably low OCF of 0.15% and a five year history that has consistently beaten the fund's index which it shares with the Lyxor fund (the FTSE Actuaries UK Index Linked Gilt All Stocks Index). Indeed, its performance is just as good as the Lyxor fund's, and the buy price of around £1.50 is much more attractive than the Lyxor fund's whopping £20.


Remember though that the longer the price-linked bond, the more likely it is to be exposed to losses from rising interest rates. This has already happened to some extent with UK index-linked gilts, even though the UK is not pursuing the same aggressive reflationary policies as the US is.


Finally, a fund providing access to global government bonds with index-linked protection against inflationary pressure: the iShares Global Inflation Linked Government Bond UCITS ETF,a fund with a Morningstar rating of Four Stars, and an OCF of just 0.20%.


What's Next?


To understand which asset classes are impacted by rising bond yields and inflation, click here for Part 2.


To read about some mutual funds and ETFs that could protect your portfolio from inflation, click here for Part 3.



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


IMPORTANT: this article contains the author's personal views only, and is not intended to be relied upon as professional investment or financial advice, for which you should always consult your own duly-engaged professional advisers.



Drop Matthew Feargrieve a Line

at www.feargrieve.co.uk

London, England

© 2020 by Matthew Feargrieve.