20th October, 2023
Where’s the Income?
It’s around 12 months since the bond market hit its lows for 2022. Around the time of Liz Truss’s budget, we added significantly to an asset class that had sold off hard and relative to the last two decades, was providing a significant annual income stream. In time, we also felt that would provide excellent capital growth potential, particularly if economies slowed, which was widely expected to happen.
Bond valuations during 2023 have ebbed and flowed on the back of slowly reducing inflation, an incredibly resilient consumer, and nearly full employment across the US and Europe. Despite economic growth slowing slightly, there has been little sign of the consumer wilting, allowing policymakers to keep their foot on the interest rate pedal all the way to 5% and beyond. The recent breakout of conflict in the Middle East has posed further questions. Alongside the awful human tragedy, it is likely to add further pressure on supply chains of oil, producing another headwind for bond markets. Incredibly, they now sit around 7% cheaper than they did a year ago (in the middle of the Liz Truss saga), and over 45% cheaper than three years ago.
We’ve talked lots about taking advantage of this opportunity, and our Lower risk portfolio’s remain bursting with income. Frustratingly though, the income hasn’t been as visible as we’d like, due to the impact of further capital falls which has offset the benefits. Without any contribution from income, the portfolios would be in negative territory in 2023. With it, they are positive, albeit not to the levels we would have hoped for this far into the year.
The graph below shows our Low to Medium Risk Portfolio over the last 12 months, comparative to both its benchmark and the Bank of England Base Rate return, which we are using as a proxy for cash returns.
In the first third of the chart, UK financing risk receded and markets were aligned to the thought that economies would slow. We therefore saw some capital growth in those early months. From that point onwards however, surprisingly resilient inflation and economic growth, allowed interest rates to keep climbing, resulting in capital losses that more than offset those early gains.
To say it’s been tricky is an understatement, but despite the challenges the income yield has come through over the course of the year and provided us with a positive return above what you would have had in cash. Relative to last year the capital value of our bond allocation is lower again, and the income yield higher (7% vs 5% this time last year), meaning the contribution from income looking forward will be even greater. The investment story remains compelling, even if it is frustrating that we haven’t yet seen the real benefits from the opportunity set.
What have we been wrong about then? Certainly two fundamental points – we expected interest rates to peak sooner, and the consumer to be weakening by now. Both have elongated the interest rate cycle and caused further gradual losses on bonds. Why were we wrong? We think the lag time between interest rate increases and people feeling the effects (as they gradually re-mortgage or slow spending) has been longer than expected. In fact it is estimated only around 25% of the impact is currently being felt, meaning that although economic data is weakening, it’s been slow and allowed interest rates to go further before everyone sees the impact. In addition, consumers have also had some protection from rising prices due to the Covid savings hangover, government support schemes to cushion energy prices for example, and supportive pay increases.
That said, our unwavering view is that rates remain at, or close to their peaks. The longer rates remain high the more the chance that economies slow, and therefore the quicker they will need to fall as the impact progressively gets felt. Reducing interest rates will be the event that kick starts capital growth in the portfolios, though even without this, the income yield is once again higher heading into 2024 than it was even in 2023. For example, in our lower risk portfolios it is now above 6%, and in the higher risk portfolios, around 4%. Just as shown in the chart above, that continues to create the baseline expectation for future returns.