What fiscal imbalances mean for bond investors

What has happened this week?

Hello, it's Friday the 12th of September. The focus over these past couple of weeks has firmly been in the fixed income markets, and most importantly the long end of the government bond curves. We've had the UK 30-year move up to around 5.7%. It's come back down a little bit since, but that's the highest level since 1998. And the US 30-year has moved up to about 5% in round numbers, which again is the highest for quite some time. Again, come back a little bit, but there's a general drift upwards in long rates, not just in the US and UK, other areas like France are also coming under pressure. 

What has caused this? 

The main cause of these moves up, of course, are the fiscal imbalances that are becoming a bit more pronounced, or certainly a bit focused on in the developed world. We've seen lots of question marks over government's ability to fund their deficits into the future. And while there's no immediate concern and immediate risk around the solvency by any means, thank goodness, I suppose what we're looking at here is investors thinking about the three areas of income versus expenditure that governments can manage and wondering whether they have the balance right. You have income as a business or even an individual would, you have income coming in the form of your tax take. As a government, you have expenditure, which is all sorts of things that governments spend money on between welfare, defence, and infrastructure and everything else in between. And in many countries like the UK, US, and elsewhere around the developed world, you've seen for quite some time, actually decades in fact, where perhaps the expenditure has been greater than the income. And that's been able to be persistent because we've been using borrowing much in the same way you would as a consumer if you needed to use a debt facility or even a credit card, governments have done the same in the fixed income markets by issuing bonds. That's a form of debt in order to make that gap between their expenditure and what they've got coming through the door. What's happened over the last few months in particular, the last few weeks has been a real focus on whether that is sustainable. We need to look at what else governments could do. Could you raise taxes? Well, that's certainly something governments are trying, but we're not exactly in a low taxation environment in many instances, and so the headroom there is perhaps limited. Or you can look at cutting your costs. And UK looked at that in parliament not that long ago and got defeated by a back bench rebellion. And also, if you look at the US's Department of Government Efficiency that started with great fanfare and ended clearly in a bit of a whimper, the savings they managed to achieve were dramatically smaller than that which were forecasted. So, you know, the income side of things, perhaps you can't do a huge amount to manipulate your tax take, unless of course you can grow substantially. That's obviously the best way to increase your revenue coming into the country. The expenditure side of things is a thorny issue. And of course, with defence spending in many ways these budgets are getting bigger, not getting smaller and so the reliance on debt remains. 

What's the impact for investors? 

Well the impact for anyone who owns fixed income, particularly longer dated fixed income is to see the price of that asset start to go down. So the capital value comes down. And the reason for that quite simply is when these bonds are issued, they're issued as fixed income securities and they do what they say on the tin. They pay a fixed amount of income every year. They generally mature at par at some points. You get if you, if you lend a hundred dollars or a hundred pounds to the government and they say, well, we'll pay you back two, three pounds a year in a fixed amount, then you understand what that yield is from day one until the end, where you get your initial capital back and you've had that income on the way. Now, because these securities have a secondary market, they're not just reliant on the primary issuance, you know, and prevailing yields can move, the income from these securities doesn't change. And so the mechanism to change the prevailing yield is for the capital value of these assets to move up or down. And we've seen examples in the past, not too distant past of course, where yields were lower than the coupons on which these bonds were issued at. And they were actually trading above par values, so you had to pay over a hundred to get a hundred back on the understanding that your yield on the way compensated you properly for that. Or conversely, if prevailing yields are higher than the coupon you're going to be expected to get from this security, they tend to trade at a discount to sort of boost that yield up, because it is income divided by price essentially. And that then gives you the right sort of level of running yield from there. So you have that debt at the security value movement. And that's essentially called duration, sensitivity to interest rates moves. And that's where fixed income managers are very careful. 

What have we done about it? 

So what have we done about it? Well, fixed income is a really important diversifier in multi-asset funds and portfolios. When you think of the equity part, the shares as the engine room, the returns driver, and you know, fixed income is as an important component you put around it to reduce the sensitivity to the volatility you get from equity markets. So as gilt's cheapened up as their yields moved up over recent years, we became more attracted to gilt's as a diversifier. We moved from an underweight position to neutral back in 2023 for the gilt market. We think it has a decent role to play today with yields where they are. Notwithstanding the fact, of course that yields have drifted up over the last few months, which has put a bit of pressure on capital values there. On the government bond side, we've actually moved our global government bond allocation in our last tactical asset allocation round, which was only a couple of weeks ago. So implementing that really as we speak, we've moved our score for global government bonds from a three actually to a positive four. So we've started drifting into an overweight position in those assets. We think that they're a useful diversifier, they're cheapening up, and we also get greater diversification by having a global government allocation rather than just allocating to the UK. So it reduces our idiosyncratic risk. And as a result of that, we think it's an even better diversifier perhaps than solely having gilts. We have a lot of gilts already, and it's valuable to have global government bonds alongside of those. Hopefully though, the other message that has really come through and you'll have picked up in markets elsewhere as well, of course, is this sort of 'one size fits all' approach to fixed income, which we saw really sort of working pretty well between the Financial Crisis and COVID as yields around the world really only went one way. That era seems to be firmly behind us. We've got interest policies being very different in different geographies, different fiscal positions, and indeed a different approach to managing fiscal imbalances, which will only really play out over many years to come. And so to our mind really underlines the importance of being active in fixed income, having an active approach to duration management, to moving around into different asset classes, credit selection as well, as yields are higher, it's ever more important. So from our perspective, as part of a diversified, disciplined and dynamic multi-asset approach, it's really important to look to use fixed income in an active way wherever you can. 

That's it from me. Have a good weekend when you get there and we'll see you next time.