Making good with bonds

23 February 2018 | Webinars


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As yields rise, how should bond investors respond? Is a strategic allocation to bonds still justified, or should investors consider taking on more risk to maintain capital value?

Senior economist Alexis Gray and bond trader Christie Gonçalves speak to senior investment writer Leo Schulz about the pros and cons of holding bonds in a rising rate environment.

Leo Schulz: Making good with bonds – interest rates are rising in the UK, in the US, and possibly soon in the Eurozone. How will that impact the bond market and what should investors do? My name is Leo Schulz, I am delighted to have with me Alexis Gray, senior economist in our London Investment Strategy Group and Christie Gonçalves, a trader on our government bond desk; welcome to you both.

If you have trouble with the quality of the audio, there should be a window on your screen giving instructions on how to dial in directly on your telephone, and this should give you a nice, clear sound. For our live listeners we will soon be swapping the dial-in instructions for a box into which you can type questions. We’ll take the questions as we go; anything that we have left over we’ll try to deal with at the end. We do have quite a large audience today so if we don’t get to you personally, we will definitely follow up.

The call will last approximately 30 minutes; the webinar earns participants a half hour’s worth of CPD points. You will need to request your certificates by contacting your usual representative, or by writing to, or phoning 0800 917 5508; I’ll bring the details onto the screen at the end of the call, so let’s get started.

What they said… “Stocks could post limited gains in 2017 as yields rise”, “Treasury yields are headed up in 2017 - the only question is how much”. Those are quotes, one from Barron’s, one from MarketWatch; both are sister publications of the Wall Street Journal, published by the Dow Jones. Christie, what actually did happen in 2017?

Christie Gonçalves: Well interestingly, what actually happened was the US 10-year Treasury started the year at 2.48, and ended at 2.42, which is six basis points tighter, and in the UK yields were flat at 1.23%.

In contrast, if we look at what’s happened year-to-date, we’ve had the US 10-year fell off 40 basis points roughly, and in the UK, 20 basis points wider.

Leo Schulz: Okay, thank you. So really the conversation today I think is going to be looking at why we’ve seen that rise in yields year-to-date, and what then is the outlook for yields going forward. So here are the topics we will cover: how the world is changing; the evolution of the bond market; the role of central banks; The new normal; The outlook for returns, and then we’ll have a quick summary of the discussion. Alexis, how is the world changing? Take us through the big picture - what are your views, Alexis, on the macro situation?

Alexis Gray: Afternoon, Leo. So in our 2018 outlook, which you can see a little snapshot of here, we talk about - in fact not only the outlook for the economy and the markets this year - but really looking medium term; a lot of our investors have much longer horizons than just one year, so it’s important to put everything in context, but for this year we’re definitely at a much stronger stage in the economic cycle than we have been for a decade.

We obviously had a big financial crisis, and a very drawn out recovery, and finally we’re seeing the United States growing quite healthily, and even in Europe and in China we haven’t seen the hard landing that everybody’s been worried about, so the environment is still quite robust, which is good news.

As a result of this, we’re seeing unemployment rates fall, so people are getting back into the job market and that’s good news. We can see that also here in the UK with the lowest unemployment rate since 1975. And so with that lower unemployment, obviously comes the risk that wages might start to pick up. It’s harder to find somebody to fill a job, you might have to pay more money, and that could then lead to higher inflation.

And I think we’ve been worrying for a number of years about a sharp increase in inflation, which just hasn’t come through, and that’s really been a global issue. We think it’s a margin this year particularly in the US, it might be finally the time we start to see some more of that inflation coming through, just because the labour market is getting so tight, right, so this is the idea of a Phillips curve; there is some inflation probably coming through.

Leo Schulz: So this is a Phillips curve, Alexis, can you just briefly explain what you mean there?

Alexis Gray: So it’s the relationship between unemployment and inflation. Generally as unemployment falls, wages have to rise because you run out of people to hire, and you have to pay them new highs, more to attract them, so then that leads to higher inflation. So we see a little bit more of a risk of inflation, particularly in the US. Unfortunately even though we’ve got this stronger backdrop and we do potentially have higher inflation, I would say the outlook for investment returns is somewhat muted.

If you think about the environment we’re in, we’ve had very low rates for a number of years, and although they will probably rise further this year, in the US we might expect three interest rate hikes, two in the UK, you know, the trouble is the starting point is very low interest rates, so for bond investors that means low returns.

Similarly in the equity market, we’ve had a very long, strong run, and so we think the valuations are somewhat stretched; so on both fixed income and equities, we have that sort of more muted outlook. We can go into the numbers later on.

So to combat this we see investors looking for yield in other places, taking on more risk. We think that the premium for taking those sort of tilts, whether it’s going into emerging markets, or credit or whatever it is, the premium is much more compressed so they might not pay off to the extent that they have in the past.

Leo Schulz: Just briefly, Alexis, before we go on, that connection between employment and inflation, so potentially what you described as being shown in the Phillips curve, you say that that connection still exists? I mean there’s not been a lot of, although employment has improved quite considerably in the UK and in the US, particularly, there hasn’t been a lot of wage inflation, has there?

Alexis Gray: No, and there’s a big debate about why this is the case. Some people say it’s because we’re increasingly using technology and machines rather than people and so that means we don’t have to pay higher wages because we can replace a person with some piece of machinery. There’s also an argument that this is related to globalisation, so it’s easy also to replace a worker with somebody in the other side of the world, who is in a poorer country, who’s willing to work for less.

So there are probably varying explanations for why we’re not seeing the typical relationship where unemployment falls and wages go up, but that doesn’t mean there’s no connection; it’s just weaker.

Leo Schulz: So we’re still waiting to see just what the strength of that connection is likely to be, is that fair to say?

Alexis Gray: Exactly. I mean there is some connection and we’re still seeing that; wages are higher than they were several years ago, they’ve grown faster than they have in the past several years. I’m not saying we’re expecting something dramatically different, but as unemployment falls it should, all else being equal, lead to some increase in wage growth.

Leo Schulz: Let’s look now at the evolution of the bond market, and what we’re looking at here are yields in the US, the UK and Germany going back over 30 or 40 years. So Christie, what do we see here? What are we finding out?

Christie Gonçalves: Thank you. Leo. I just want to add something on how the world is changing. We’ve discussed inflation risks and we’ve discussed growth being on the rise, and I think it’s normal to assume that when you’ve got increasing growth, and increasing inflation that central banks would look to start unwinding this unconventional monetary policy that has been employed over the last few years.

Leo Schulz: By that you mean quantitative easing.

Christie Gonçalves: Quantitative easing, yes, and I think that’s part of the normalisation process, and that is part of the reason why we’re seeing those yields higher this year than they have been in the recent past. So if we dig into that a little bit deeper and we explore where we think yields are going in the future, it’s quite important to look at where we’ve come from.

And if you look at this slide, we look at the last 30 years of the global bond market yields, looking at the UK, the US, and Germany, and you can see that we started 30 years ago at over 10% in the US, and yields have come down a long way since then to current levels in the US of below 3%.

So that is effectively a bull market over the last 30 years in bonds. If we look at what caused that bull market in bonds, or what caused yields to come down so much lower, the first big driver was central banks declaring war on inflation in the late 1980s, and this caused inflation expectations to be set so much lower.

The second big driver is obviously more recent to all of us, and that was post the global financial crisis in 2008, when central banks started employing this unconventional monetary policy, which caused yields to take another leg lower, and even go negative in the case of Germany.

So if we look at all of this, we can see that yields rising from current levels of the lowest 3% in the US, are part of a normalisation from very low levels, especially when you consider that for most of the early 2000s, and this is post the dot com bubble, 10-year yields in the US were around averaging 5%, and that was actually considered quite low at the time.

And now if you look at current forecasts, where people talk of a bear bond market, and see it as a bear bond market, they’re not even looking at 5%, so normalisation is something that’s part of a normal cycle.

Leo Schulz: So we’re going to look a little bit more at normalisation in a few moments, and it is a really interesting point. I think this evolution of the market over the past 30 years is really interesting and I just wanted to have a couple of words from both of you if you don’t mind on what have been some of the key drivers of that evolution? Why have yields come down so dramatically over this particular period?

Alexis Gray: I think in a moment we’re going to take a longer look back at where we came from, which gives you some sense of why yields came down. It was quite unusual in fact to have yields as high as they were in the 1980s compared to history, but that was an unusual time when of course you had very high inflation, you had the oil shocks of the 1970s, and I think the central banks sort of lacked credibility on fighting inflation.

They didn’t necessarily target a low level of inflation. Governments often influenced decisions rather than central banks being independent, so there was a big shift over that time. Most central banks moved to inflation targeting and now inflation expectations are very, very well anchored at roughly around 2%, so that was I think one of the most significant drivers, and as Christie has obviously mentioned.

Christie Gonçalves: The unconventional monetary policy stimulus being the quantitative easing, which started with the US in 2008, when they started buying government bonds, effectively printing money, with the central banks buying bonds issued by the Federal Reserve. And then we had the ECB following by actually extending that programme, and also buying corporate bonds, and of course the Bank of Japan also implementing QE to a large extent.

Leo Schulz: So let’s talk a little bit more about QE, Christie, and your views around that, because I think one thing that is leading to higher yields is of course that central banks are starting to withdraw from QE. What is it that we’re looking at here?

Christie Gonçalves: So what we’re looking at is balance sheets from five of the central banks, and what’s important to note about this is that when we talk about the unwinding of these quantitative easing measures, we’re talking about for example in the ECB’s case, buying fewer bonds each month; so they’ve cut their bond buying from 60 billion to 30 billion euros, with the strong likelihood that at the end of this year they’re not going to be buying new bonds.

Leo Schulz: That’s the European Central Bank

Christie Gonçalves: That’s the European Central Bank, yes, and that’s what we talk about when we talk about the flow argument, so that’s new money coming to market and supporting the market. But what’s important to remember is stock.

Leo Schulz: The US and the UK of course have stopped buying for some time now

Christie Gonçalves: The US has stopped buying for some time now yes, and they’ve actually hiked interest rates five times already, but they still have this balance sheet that’s quite expensive. It’s still supporting the economy, and this graph shows you five of the balance sheets. It’s now over 12.7 trillion euros that are still supporting the market because although they’re not buying new bonds, or adding new money to the market in the case of the US, they still have this balance sheet of bonds that’s still supportive of the economy.

Leo Schulz: And this is what you want to talk about with stocks and flows.

Christie Gonçalves: That’s correct, yes. So the flow argument is really about how much new money is coming into the market. So in the case of the ECB, they still have 30 billion euros of new money coming in to the market each month, which is supporting the market. That is the flow argument, which we all agree is becoming less significant, as they’re buying fewer bonds and it will be phased out towards the end of this year.

But what the market is likely to focus on more, and what we want emphasised is the stock argument, which is where are the cumulative purchases that are already on the bank balance sheet that are still supporting the economy. That is still very extensive if you look at this graph, and I’m going to ask Alexis to give a nice analogy to just really hit home what the difference is between the stock and the flow argument.

Alexis Gray: I mean one way to think of all these asset purchases is really like building up a pile of wood; each time a central bank goes out and does QE and buys bonds, they’re adding another log to the pile. Recently we’re seeing some of the central banks stop adding to the pile, so that’s the US and UK, and the ECB will probably stop adding by the end of the year.

This year the US is already starting to take logs off the pile, right, so this pile, all else equal, will shrink. So I guess the point is that central banks and they are huge owners of government bonds across the world and to a certain extent corporate bonds - they own 20-30% of the market depending on which country you’re in - so it’s a huge support and one reason why bond yields have remained so low.

So that is not all about to be reversed. We’re very much at the tipping point, and where this goes, I mean to the right you see we have the forecast for several years, but whether we really normalise back to where we were pre-crisis, remains to be seen. So we’re not stripping everything back, you know, necessarily, we’re just no longer building up the pile even higher.

Leo Schulz: Do we have any sense, Alexis, about the pace of taking logs off the pile, as you put it?

Alexis Gray: Well we have some sense in the US; they’ve given us a set of ranges of how much they intend to withdraw slowly over time, they’re actually not selling the bonds that they bought; they’re just allowing them to mature and not taking that money and reinvesting it.

The ECB and The Bank of England are not yet talking about that process yet. I think they would want to raise rates in the same way that the US central bank has done, before considering doing anything with the balance sheet, so there are probably several more years before we get them taking their logs off the pile.

Christie Gonçalves: Yes, just to put that into context, the US actually stopped with their quantitative easing buying in 2014, and only at the end of 2017 did they start allowing bonds to mature and fall off the balance sheet. So if we look at where we are with the ECB, if they decide to stop with their new purchases in December, it’s still going to be a good few years of reinvestments before they actually decide that they’re going to start unwinding their balance sheet and allow maturities to actually expire and fall off the balance sheet without reinvesting them. So there’s still a good few years of support for the market.

Alexis Gray: And I think that central banks know very much that what they have done has pushed down bond yields and pushed up asset prices; that was the intention, but that’s the mechanism by which this works, and that if you reverse it, it could have the reverse impact.

So they’ll be very cautious; they don’t want to cause some sort of massive market sell-off. I think this is going to be very, you know, it’s uncharted territory and they will tread carefully. That’s not to say that there isn’t a risk, but I’m saying I don’t think they’ll willingly disrupt the market.

Leo Schulz: You mentioned at the beginning in your opening remarks, Alexis, that it’s been a very drawn out recovery, but it’s not really over just yet, is it in many ways? Shall we just look at actual interest rates particularly at central bank interest rates and what our views are there?

Alexis Gray: Obviously the historical context is we had interest rates well above zero before the financial crisis, I mean we can all remember rates being 5% plus; you go back even further, more than 10% level of interest rates, but we’ve had an unusual decade of rates near zero. I mean fortunately we’re at a point where we no longer need interest rates so low because the economy is much stronger, and I think that’s really good news.

The normalisation is obviously uncharted territory, we’ve never been in this situation before, and so there’s nervousness about what this could mean for asset prices, and I think that’s warranted to be thinking about it. It really depends on where rates go in the long term, so on the chart here we have what the market is now pricing in, in terms of interest rate hikes, and that is for US rates to get to about 2.5% to 3% over the next several years, which would be roughly a new equilibrium.

The UK would be gradually following suit, in fact I think even though Brexit is disruptive, I think the Bank of England will continue to raise rates through that process, unless there’s something drastic, some sort of recession or something quite drastic, and the ECB will eventually follow suit.

Rates are rising; it’s generally good news. I think that we’re not going back to where we were necessarily pre-crisis; we’re in a lower growth world than we had previously, and so 2.5% to 3% is roughly where we think the rates will settle across those markets, except Japan which has still much bigger problems fighting deflation.

Leo Schulz: And these forecasts are taken from forward pricing, isn’t it; so this is roughly what the market is expecting.

Alexis Gray: Right; so this may not turn out to be right, but this is roughly what the market expects and if anything I think rates may rise faster in the UK, we might be being too pessimistic about the impact of Brexit over the next couple of years.

We obviously know that yesterday a transition deal was agreed between the UK and the EU, which sort of smooths the process and leaves a longer time frame for companies and the government to prepare. We don’t know what deal will be struck in the end and what type of Brexit that is, but I think that for the next several years the economy might get back to a little bit more BAU.

Leo Schulz: What would be your view, Christie? Are these the kind of levels and this pace something that the market feels relatively comfortable with?

Christie Gonçalves: I think what’s going to be interesting is what happens with the Fed, because the market is currently pricing at around three hikes from the Fed, and we’ve got a new Fed central bank chair, Jerome Powell, who has his first FOMC meeting, which starts today, with the announcement to come up tomorrow.

Leo Schulz: The FOMC is the Federal Open Markets Committee, which sets interest rates in the US.

Christie Gonçalves: For the US, yes, and he has made one public statement where he came out as more hawkish than his predecessor, Janet Yellen, so the market is quite curious to see what happens with the interest rate meeting tomorrow, as well as what happens with the dot plot. And the dot plot is really where do the FOMC members think interest rates are going?

Leo Schulz: So Thursday will be the announcement; is that right, is there an announcement tomorrow or an announcement on Thursday?

Christie Gonçalves: Tomorrow; I think the Bank of England is on Thursday. Yes, so I think what’s going to be very interesting is to see what happens with that dot plot because currently the dot plot is pricing in three interest rate hikes for this year, 2018, by the US Fed, but if they are actually more hawkish than that, we could see four hikes priced into the dot plot, and then you could see some form of a reaction in the market.

Leo Schulz: And that would take rates to about 2.5% if there were four this year. So let’s just put that into the longer-term context; so we looked at the 30-year evolution and this I think is the 300-year evolution? So what are we reading here, Alexis?

Alexis Gray: So we’re looking at a long term chart of bond yields in the UK. This is from the Bank of England, it’s about 300 years’ worth, and I think it’s important to consider that longer-term context because most of us can only remember bond yields falling, and so the worry is of course that what’s just happened over 30 years will be completely reversed over the next 20 or 30 years.

One reason why that may not be true is that of course looking at history, bond yields have tended to, the average has tended to be around 4% to 6%; so the unusual point in history is not necessarily now, but where we just came from, in the 1970s and 1980s.

That doesn’t automatically imply that bond yields will remain at the historical average, we may be in unusual times, but I think as I mentioned before, we have this unusual period in the 1970s and 1980s where inflation was completely out of hand, central banks didn’t have a credible framework; we had this oil price shock, and so interest rates and bond yields were much, much higher and I think it’s highly unlikely we go back to that sort of phase again.

I think that we’re going to oscillate in a lower range than where we have historically; so although bond yields are going to rise over the next several years, I wouldn’t say that we’re expecting anything too dramatic, even, it would have to be a very extreme scenario.

Leo Schulz: And that’s I think you mentioned, didn’t you Christie, that 2.5% to 3% is roughly where you would expect rates to settle

Alexis Gray: That would be short-term interest rates; for a longer-term bond yield, if there’s a term premium for investing over a longer horizon, that should be that short rate plus some additional benefits.

Christie Gonçalves: Yes, that’s correct.

Leo Schulz: So let’s just have a look at what that’s likely to imply for returns in the bond market, Alexis, if you could explain to us what we’re seeing here.

Alexis Gray: So what we’re looking at here are some forecasts for bonds in various parts of the market; so starting with UK credit, UK gilts, UK Stirling aggregate bonds, and we’ve got global bonds ex-UK, and then we’ve got UK cash down the bottom. So each one of those lines shows you a range of where returns, so nominal returns for an investor, on average over 10 years; the middle line, which is the middle of that red box, tells you our median and then the whiskers, the lines that go out to the side, show you the range.

So there’s no great certainty exactly about what the returns will be for a bond portfolio, but this is a reasonable range; so you can see that those medians generally fall around 1.5% to 2%. So if you imagine that inflation’s going to be roughly around that level as well, real returns for bonds will probably be around zero, which is obviously quite challenging for anybody who is a retiree or who relies on a stable income stream, so it’s a challenging environment to be a bond investor. This is largely because interest rates are so low, and they have a significant relationship with what bond returns would be.

Leo Schulz: But as yields rise, even though they’re not going to rise to where they were; as yields rise, that’s going to be a good thing for income investors.

Alexis Gray: Yes, and to be honest the worst case scenario in these box and whiskers, are that the left hand side forecasts are actually places where interest rates remain very, very low because then we never get the pick up in yield that we need, which means we never get higher coupon rates, we never get a higher coupon stream. So in effect, rising interest rates means that eventually your income stream will build back up again.

As we see the pathway there, though, there’s a capital loss, that’s how bonds work, as rates rise that means that some bond prices go down; so the benefit of rising yields actually comes afterwards, so it’s sort of short-term pain, long-term gain.

Leo Schulz: So why would you stick with bonds in your portfolio in this scenario?

Alexis Gray: I think it comes back to the point that you don’t hold bonds for growth, you hold them for diversification. Over a long time frame we would expect equities to outperform bonds, but bonds tend to behave in the opposite way to equities, particularly when the equity market falls, bonds tend to rise.

But there’s that offsetting factor, and they have this stable income stream, so they’re basically an anchor in a portfolio, and that’s true regardless of where we are, with interest rates.

Christie Gonçalves: I think it’s important to just add there the role that bonds play in terms of their much lower drawdown than equities; so if you do see a sell-off in bonds, the extent of your losses is a lot lower than equities in an equity market sell-off, which is one of the key characteristics of bonds in a diversified portfolio.

Alexis Gray: And then we often talk about the risk of a bear market in bonds; even in that scenario, you know, the sell-off in bonds; if you were in high quality, investment grade, government bonds, that sell-off was 5% to 10%. If you were in maybe emerging markets or corporate bonds, the riskier parts of the market, it might have been a larger sell-off, but if you think of what happened during the financial crisis, equities sold off by 50% or more. So we’re not talking about the same dramatic losses in a bond bear market as you would have in an equity market.

Leo Schulz: So there’s a ballast, I think is a word that’s often used. Just to summarise your views; in terms of the risks, we talked about the stocks and flows around QE and starting to reduce the wood pile. Once you get that image in your mind it’s hard to go anywhere else, isn’t it, but what are some of the risks that you would see, Alexis?

Alexis Gray: I mentioned three risks here, and there are two types of risk actually I would say: one risk is that rates rise very quickly and bonds sell off, and that could happen if we unwind QE; we’re in uncharted territory, so we don’t really know how the market might react; we might see a sharp sell-off, that’s one risk.

A second risk would be that there is an unexpected increase in inflation, so finally we start to see wages picking up because the labour market is strong, and that would also lead to higher interest rates, and probably a sell-off in the market.

I think the other risk we need to also consider is what happens if rates never really lift off from zero? Because in that instance you never get back that income stream that you’ve been looking for. We have these low rates, low yields, and low income stream, and the type of scenario where that happens might be one where productivity growth is low, economic growth is low, and we just get stuck in a low-yield world permanently.

Christie Gonçalves: So what do we expect? We expect gradual, controlled normalisation of monetary policy. The central banks have worked way too hard to get us to where we are now to risk undoing that by doing anything drastic.

Leo Schulz: So that’s quite a good thing, isn’t it, the fact that you’ve got this gradual controlled normalisation, this withdrawal of emergency measures? that’s really telling us that, as you were saying earlier on Alexis, that the world is actually in quite a good place now.

Christie Gonçalves: Definitely; it’s from a position of strength that the central banks now feel that they can start withdrawing these emergency measures that were employed post the global financial crisis.

So in addition to that we see lower total returns over time as we do feel that we’re moving into the lower absolute return environment, but we see improved prospects for income as yields lift higher; the short-term pain as a result of the capital loss, but long-term gain as interest rates ultimately set at higher levels.

Leo Schulz: And of course in the meantime bonds continue to play a very important role in a portfolio. Interest rates are rising and yields will rise as a consequence. This is a sign that the world is in a better place. Economies are growing, employment is good; there is a level of healthy inflation. Central banks feel ready to withdraw from what were emergency measures, but the pace will be slow and we are likely to return to levels that remain low by historical standards.

Vanguard are currently offering adviser workshops on fixed income; the workshops will cover some of the general outlook, but will also look in quite a bit more depth at the role of bonds in a portfolio; we are also doing workshops on how to blend active and passive investments.

If you would like to take part in a workshop on either of these topics, or indeed on both, you can see the details on your screen now, either call your representative, or call 0800 917 5508, or email The workshops can claim CPD credits and this call can also claim CPD credits, and to do, as I said at the beginning of the call, you can use the same contact information as is currently on the slide on your screen now.

And I will be back next month at the same time, at 2 pm on Tuesday 17 April; the topic will be Emerging Markets: what you need to know. Our guests will be Jonathan Lemco, a senior investment strategist based in our US office, and Nick Eisinger, co-head of active emerging market investments in the fixed income team, if you would like.

I think that is us for today; thanks to Christie and Alexis, and thanks to all our listeners.

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