Vaccine success prompts bond sell off

Laith Khalaf
25 February 2021

•    The 10 year UK gilt yield has risen to 0.75%, from 0.2% at the start of 2021
•    It’s now trading above pre-pandemic levels
•    Bond prices are falling, and yields are rising, as markets are digesting inflation risks, and the prospect of interest rate rises, as vaccines help economies recover
•    Some ‘safe’ default pension funds are down 8% since the start of the year
•    What should bond investors do?

Laith Khalaf, financial analyst at AJ Bell, comments:

“Bond investors have had a pretty rocky start to 2021, and if the global vaccine roll-out prompts a sharp economic recovery, price falls clocked up this year could be just the beginning. This is of course on the back of a tremendous run of performance, stoked by low interest rates, and quantitative easing. Yields have fallen to such record low levels that the bond market is like a coiled spring, ready to twitch into action at the first sign of inflation or interest rate rises. 

“That trend looks to be taking root in the bond market at the moment. Vaccines are literally a lifesaver, but for the bond market they spell trouble. A recovering economy means central banks don’t have to offer as much stimulus and at some point this year they might even start gently whispering about when to withdraw QE or raise rates. Given how much the bond market has been propped up by central bank activity, kicking away this crutch will inevitably lead to a fall in prices. Markets will look to pre-empt central bankers and that’s probably why we’re seeing yields rising now. 

“The mellow scenario for bonds is that rising yields tempt in new investors and there is a nice, gentle deflation of the bond bubble. The difficulty is, in an environment where interest rates are on the up, not many people are going to want to invest in bonds because their prices are likely to fall and the yield you can pick up tomorrow will beat what you can buy today. However, there are some institutional investors, in particular pension funds and insurance companies, that are bound by convention, regulation and contractual obligation to buy bonds, and their blind support for the market may provide some buoyancy.

“For the most part these institutions hedge, or manage, the investment risk on behalf of consumers. But there is one area where savers themselves are heavily exposed to bond market falls, just as they are about to retire. Many old company pension plans use a process called lifestyling, which automatically shifts pension savers out of equities and into bonds just as they are about to retire. This strategy has worked a treat as loose monetary policy has led to rocketing bond prices, but if that trend goes into reverse, pension savers will see big falls in their retirement pots, just as they are about to draw on them. So far in 2020, the average lifestyle fund has fallen 8% in just two months. For many savers, the decision to default their money into these funds was made by someone else, a long time ago. Few probably appreciate the risks that have been assumed on their behalf.

“It’s important to keep some perspective on where we’re at because the 10-year gilt still stands at 0.7%, a level which is so low it would have been unthinkable before the financial crisis. Bonds still offer diversification for a mixed portfolio because prices could rally if the pandemic takes a turn for the worse, or economies fail to deliver the growth that re-opening promises. But the quakes we are seeing in the gilt market today are at the very least a reminder of the price falls that bond investors might face when the QE music stops, and the low yields currently on offer don’t offer a great deal of compensation for that risk.”

Bond sector performance

“All of the major bond sectors are nursing losses so far in 2021 apart from high yield bonds which tend to have a greater correlation with equities and risk appetite generally. Strategic, corporate bond and global bond sectors have held up better than government bond funds, as they tend to be shorter dated, reducing the duration risk of the portfolio. Credit spreads also tend to tighten in risk-on markets, which lends some support to prices. Strategic bond funds and global bond funds have more flexible mandates than other sectors, which allow them to invest in bonds across the globe and up and down the credit spectrum. This gives the managers greater scope to dodge the areas which stand to be hardest hit by potential interest rate rises.

“Long dated government bonds sit at the bottom of the pile so far this year. The duration risk from long maturities means that each percentage point rise in yields levies a far greater toll on prices. Equally, when yields are falling, these longer dated bonds will perform best, which has been the story of the last ten years. Consequently these sectors have enjoyed stellar returns since 2010."

Investment Association/ ABI fund sector

% total return 2021 YTD

% total return Dec 2010 to Dec 2020

% annualised return Dec 2010 to Dec 2020

IA Sterling High Yield

1.3

70.4

5.5

IA Sterling Strategic Bond

-0.7

69.4

5.4

IA Sterling Corporate Bond

-2.6

78.8

6.0

IA Global Bonds

-2.9

49.4

4.1

IA UK Gilts

-6.7

72.4

5.6

ABI Sterling Long Bond ('Lifestyle' pension funds)

-8.3

119.9

8.2

IA UK Index Linked Gilts

-8.7

116.9

8.1

Source: FE, total returns figures

Lifestyle pension funds

“Until the last five years or so, it was common for company pension schemes to automatically switch savers out of equities and into bonds as they approached their retirement date as part of their default strategy. This switching still applies to default fund investors even if they have left the company where they built up the pension. The nature of imposing a one-size-fits-all investment solution that a worker keeps for their entire life means that decisions made by trustees, pension scheme managers and advisers in the 1990s are still playing out today.

“One or two things have changed since then. The main reason for implementing a lifestyle strategy was to hedge against annuity rate fluctuations, as these move in the opposite direction to bond prices. But since the Pension Freedoms were introduced in 2015, pension savers haven’t been funnelled into buying an annuity, and many are now investing their pension, or drawing it in cash. Many company pension schemes and corporate advisers have therefore moved away from a lifestyling approach in modern default strategies. But those older pensions are still set on their course, unless pension savers themselves choose otherwise.

“The lifestyling approach has actually been incredibly successful while interest rates have been falling. Bond prices have risen, offsetting falls in annuity rates, and even if you’re not buying an annuity, an annualised 8.2% average return over the last ten years isn’t to be sniffed at. But if, and when, interest rates rise, these lifestyle funds will suffer, and year to date they have on average lost 8%. If yields rise, those buying an annuity will be compensated by rising annuity rates, so the income they achieve should be broadly level. Those who aren’t buying an annuity will not find such solace, and for these lifestyle fund investors, the risk of rising interest rates is high, and could come home to roost at the worst possible time - just as they are about to retire.”

What should bond investors do?

“Investors should consider why they have an allocation to bonds. There are broadly speaking three reasons for investing in this asset class.

1. Diversification

“Bonds still offer diversification from equities, and if risk appetite wanes, bonds funds can be expected to do well when equities fall. This still holds true today, though with bond prices already so high the upside is much more limited than the downside. The benefit of holding both bonds and equities together is these assets minimise portfolio volatility, though this may come at the cost of longer-term returns. Instead of managing the bond-equity split themselves, investors might consider a multi-asset fund which does it for them, like Personal Assets Trust or Rathbone Total Return. These funds won’t shoot the lights out when risk appetite is high, but they are run by managers with experience in making allocation calls between shares, bonds, and other assets like gold, and who run their funds pretty conservatively.

2. Income

“The income produced by a bond portfolio has fallen in line with loose monetary policy and has already pushed many income seekers out of the bond space. Long term income investors who don’t mind some rough and tumble in capital prices might consider a UK Equity Income fund like City of London investment trust, which currently trades on a yield of 5.3%. The investment trust structure means manager Job Curtis can hold back some of the portfolio’s dividends in good years to pay out in fallow years, providing a smoother income stream for investors. Those who prefer to hunt for income in the bond world might consider higher yield bond funds like Baillie Gifford High Yield Bond fund, but these come with added equity-like risk.

3. Protection

“Some investors choose bonds because they have low volatility and are generally considered safe. However, one has to question whether a high allocation to bonds right now is actually an accident waiting to happen; pension lifestyle fund investors fall into this bracket. For those who are thinking about buying an annuity with their pension, a lifestyling approach using bonds still hedges their bets on annuity rates, so might not need to be tinkered with. For those who are looking to just draw their pension as cash, gradually switching into cash rather than bonds might be a better idea. 

“For those who are planning to continue to invest their pension and draw an income, then gradually switching into a portfolio of income funds like City of London Investment Trust, Evenlode Global Income or Man GLG UK Income might be worth considering. A mix and match approach to cash, annuities and investment income requires a combination of strategies. If you have lots of old company pensions scattered hither and thither, you might find them easier to manage if you consolidate them in one place. And seeing as this is the point at which your pension savings will be nearing a peak, it might be worth seeking professional financial advice.”

Laith Khalaf
Financial Analyst

Laith Khalaf started his career in 2001, after studying philosophy at Cambridge University. He’s worked in a variety of roles across pensions and investments, covering both the DIY and the advised sides of the business. In 2007, he began to focus on research and analysis, and has since become a leading industry commentator, as well as a regular contributor to the financial pages of the national press. He’s a frequent guest on TV and radio, and for several years provided daily business bulletins on LBC.

Contact details

Mobile: 07936 963 267
Email: laith.khalaf@ajbell.co.uk

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