In the last edition, I outlined my thoughts that many asset values are looking expensive in historical terms. Just to remind you the US equity markets are at all-time highs, the UK market at the time of writing this very close to all-time highs, European markets are showing signs of a decent recovery and pushing historical highs. More importantly, although less easy to see and understand, is that the prices of long-term Government bonds and corporate bonds have already reached historical highs, and are showing signs of reversing a 30-year ‘bull market’.
It is the reversal in these bond prices that could cause a downwards price shift in other assets, so it is important to understand the dynamics here.
The word ‘Bond’ means many different things in the financial world, but in this context, we are looking at loans issued in the main by Governments, and also by large companies. You will read repeatedly in the press about the debt the UK Government has, and this debt is in the form of long-term loans (called Gilts in the UK) that investors can ‘buy’. The interest is paid to the investor, called a ‘coupon’, and the capital is repaid to the investor, usually after a very long term of 15 years +. This all sounds very safe, and traditionally Gilts and other developed economy Government bonds, such as German Bunds and US Treasuries, have delivered very low-risk returns for investors. Gilts, and other bonds, however, can be bought and sold on the stock market. This means that the value of the bond will vary dependant on the perceived creditworthiness of the issuer, and most importantly, open market interest rates.
I can illustrate this as follows. Let’s say I have bought a hypothetical bond issued during the credit crisis with a coupon of 2.5% and another 20 years to maturity. As the economy recovers and interest rates rise, what would someone pay for my bond if it is thought that interest rates rise to over 2.5%? Potentially much less than I paid for it as there is a chance that long-term interest rates rise well above the coupon of the bond, so a buyer will only offer a lower price to offset the lower ‘interest’ payments from the bond, but knowing that if he holds it to maturity it will give him the maturity price.
This dynamic affects (£) trillions of UK Gilts, German Bunds, and more important US Treasuries. It is the US economy that has recovered most since the crisis, and is likely to see a further boost from Trumps recently delivered corporate tax improvements. This has led to US interest rates starting to rise, slowly for now, to slow down the boom to help stop inflation running too high, however, there is plenty of evidence to suggest that the Fed have been too slow in raising rates, and that 3 % inflation and 3% interest rates will become the new norm in the US. This does not bode well for the huge amount of Bonds issued in the crisis with coupons much lower than 3 %, and indeed at the time of writing we have seen US Treasuries 10 year yield rise to 2.7 % as existing bonds fall in value.
It is this correction of long-term interest rates that pose most risk to global investment markets. If bonds of all types fall in price as interest rates rise, what will happen to the ‘High Income’ equities that have been driven up in price? Their dividends will begin to look unattractive relative to interest rates, and if they have low growth prospects, such as utilities or retailers, what return can you expect from them in the future? I am certain that equity returns from the larger income stocks will be lower than over recent years, and investors will need to start looking at areas of relative value. This could be ‘unloved’ stocks in the UK, markets in economies that are behind us in the recovery phase, or simply companies with good growth prospects that haven’t been spotted by the markets yet. They are out there, they are just difficult to find!
It may be the time to look for help from an investment professional to help negotiate the tricky times ahead. You will not be able to rely on the momentum of the market we have had over the last 10 years, that has been fuelled by super-low interest rates and Governments buying financial assets. As rates rise and Governments stop buying, value, not expensive income, will be the winning strategy!
Martin Lamb – Joseph Lamb