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Higher inflation, bonds rally

  • 16 June 2021 (5 min read)

Without question, strong economic growth, higher inflation and therefore higher interest rates from central banks are bad for bond returns. As clients asked on our recent Asian and Spanish roadshows, “why would we buy bonds now when the Fed may raise interest rates?

And yet, that same combination of higher growth and inflation has played out with positive returns from US Treasuries in recent months. The last Friday in May once again saw higher inflation data in the US, with bonds counterintuitively rallying. In fact, US Treasuries have been posting positive returns since mid-March and investors are starting to question whether the 2021 “bond bear market” is another false dawn for those that expect a normalisation of interest rates and yield curves.

So, what is going on, and how do we respond to potential client scepticism around government bonds?

Our response and subsequent debate centres around two ideas:

  1. The bond market’s ability, like every other liquid market, to be a forward-pricing mechanism
  2. Markets are never driven purely by macro-economic factors

Why is the market rallying? This comes back to point one; perhaps investor expectations for inflation and growth are so high that, despite ongoing high prints in inflation, the data is simply not high enough to shock those expectations. Or, maybe the fact that the expectations of high data in January/February were enough to move yields higher, but now investors are more focussed on the second half data that is pretty consensually going to be much lower than in the first half of the year, due to the well-versed arguments about inflation being transitory.

Year-to-date returns across fixed income
Source: AXA IM, Bloomberg. Performance data provided as at 31/05/2021 on a cumulative basis, rebased to 100, for the AXA Global Strategic Bond Fund Z GBP since 2021, net of ongoing charges.

Please note that the fund is managed on a total return basis without reference to any market index. Past performance is not a guide to future performance.

Please note that that the AXA Global Strategic Bond Fund was launched in October 2020. A longer-term track record exists for the offshore product, AXA WF Global Strategic Bond Fund I (H) GBP, as shown below.

2016 2017 2018 2019 2020
7.29% 2.85% 0.92% 7.76% 5.94%

Source: AXA IM, June 2021. Performance shown net of fees. Past performance is not a guide to future performance.

To address the second idea, economic data is important, but factors such as supply and demand, investor sentiment and positioning also influence market movements. Which is why we put so much emphasis and effort into our MVST framework1  that considers a diverse range of factors influencing markets.

Over the last few months, we have spent more time considering the sentiment and technical factors, where analysis has helped challenge our very bearish duration exposure in February/March and led us to add duration. Anecdotal evidence suggests that many of the short duration positions are now under water and the infamous “short squeeze” is forcing investors to close those positions as the market rallies away from them. Ultimately the best justification for a rallying market is “more buyers than sellers”. Beautiful in its simplicity.

With current duration exposure of 4.37 years we are a long way from the low 1.5 years and “capital protection” strategy that we were running back in the first quarter of this year. In May we talked about how we added 30-year US treasury exposure, and we once again added US exposure in mid-June, but more in the ten-year part of the curve. But for sure we now have a decent exposure to a rallying US Treasury market.

  • TWFjcm8sIFZhbHVhdGlvbnMsIFNlbnRpbWVudCwgVGVjaG5pY2Fscw==
Duration position for Global Strategic Bonds
Source: AXA IM, 31/05/2021. Chart shows evolution of month-end duration for AXA Global Strategic Bond Fund Z GBP, broken down by currency from 31/01/2021 – 31/05/2021. Today refers to positioning as of 14/06/2021.

Elsewhere, year to-date we have seen decent and positive contribution to returns from high yield, where both the total return and the relative to market return have been strong. Emerging markets spreads have also contributed. We have reduced our credit default swap (CDS) position to allow our long credit and high yield positions to run with more risk. And last, our inflation breakeven exposure, which remains at a relatively elevated 10% of the portfolio, has outperformed the equivalent in conventional yields. So while bond total returns have, on the whole, been negative year-to-date, our strategy went into positive (albeit very small) territory year to date at the end of May.

Returns across fixed income, year-to-date

  Return (%)
European high yield 2.4
US high yield 2.3
European inflation-linked 1.4
US inflation-linked 0.8
Global Strategic Bonds 0.0
European investment grade -0.9
Emerging market debt -1.4
US investment grade -2.7
UK inflation linked -2.8
German Bunds -3.2
UK investment grade -3.4
US Treasuries -3.5
UK Gilts -6.3

AXA IM, Bloomberg, 31.05/2021. Performance data provided as at 31/05/2021 on a cumulative basis for the AXA WF Global Strategic Bonds I USD Fund Z GBP since 2021, net of ongoing charges. Past performance is not a guide to future performance.

Is the bond bear market over?

So, to return to my question at the start: why buy bonds? Hopefully, we have outlined the short-term rationale behind our decision to add to duration. You can agree or disagree about that view but remember that we are running a strategic bond portfolio, not simply a government bond fund.

Of course, clients also ask a slightly different question: is now the right time to buy into fixed income? Our response tends to be two-fold: firstly, in theory, one of the major benefits of running a flexible, unconstrained strategy is that there is no "one" time to invest, given that we have the ability to adapt our allocation and positioning to the point in the economic cycle.

Secondly, however, this does not mean that we will necessarily deliver strong positive returns in any environment. 2021 has been a reminder of the latter and the strategy has managed to navigate through the bond bear market with a flat return YTD, and in the last few weeks we have started to turn that into a positive return.

Does that mean that the bear market is well and truly behind us? We would argue that the worst of the sell-off may have already happened, but do not rule out the possibility for further volatility – given the uncertainty in economic data and the fragility of the ongoing recovery out of COVID. That said, we are more interested in what is and isn't priced into markets and believe that, as we saw with last week's US payroll data, bond yields could rally with any potential undershoot of the market's high expectations, meaning that the risk/reward balance for us has shifted to a more constructive view on duration.

We would also argue that our strategy can offer investors' benefits beyond outright returns, namely much needed diversification to sit alongside their equity allocation, as well as a strong focus on ESG integration (more on which to come next month).

Counterparty Risk: failure by any counterparty to a transaction (e.g. derivatives) with the Fund to meet its obligations may adversely affect the value of the Fund. The Fund may receive assets from the counterparty to protect against any such adverse effect but there is a risk that the value of such assets at the time of the failure would be insufficient to cover the loss to the Fund.

Derivatives: derivatives can be more volatile than the underlying asset and may result in greater fluctuations to the Fund's value. In the case of derivatives not traded on an exchange they may be subject to additional counterparty and liquidity risk.

Geopolitical Risk: investments issued or traded on markets in different countries may involve the application of different standards and rules (including local tax policies and restrictions on investments and movement of currency), which may be subject to change. The Fund's value may therefore be impacted by those standards/rules (and any changes to them) as well as the political and economic circumstances of the country/region in which the Fund is invested.

Interest Rate Risk: fluctuations in interest rates will change the value of bonds, impacting the value of the Fund. Generally, when interest rates rise, the value of the bonds fall and vice versa. The valuation of bonds will also change according to market perceptions of future movements in interest rates.

Securitised assets or CDO assets risk: Securitised assets or CDO assets (CLO, ABS, RMBS, CMBS, CDO, etc.) are subject to credit, liquidity, market value, interest rate and certain other risks. Such financial instruments require complex legal and financial structuring and any related investment risk is heavily correlated with the quality of underlying assets which may be of various types (leveraged loans, bank loans, bank debt, debt securities, etc.), economic sectors and geographical zones.

Emerging Market Risks: emerging markets or less developed countries may face more political, economic or structural challenges than developed countries. As a result, investments in such countries may cause greater fluctuations in the Fund's value than investments in more developed countries.

Liquidity Risk: some investments may trade infrequently and in small volumes. As a result, the fund manager may not be able to sell at a preferred time or volume or at a price close to the last quoted valuation. The fund manager may be forced to sell a number of such investments as a result of a large redemption of shares in the Fund. Depending on market conditions, this could lead to a significant drop in the Fund's value and in extreme circumstances lead the Fund to be unable to meet its redemptions.

Credit Risk: the risk that an issuer of bonds will default on its obligations to pay income or repay capital, resulting in a decrease in Fund value. The value of a bond (and, subsequently, the Fund) is also affected by changes in market perceptions of the risk of future default. The risk of default for high yield bonds may be greater.

Risks linked to investment in sovereign debt: Where bonds are issued by countries and governments (sovereign debt), the governmental entity that controls the repayment of sovereign debt may not be able or willing to repay the capital and/or interest when due in accordance with the terms of such debt. In the event of a default of the sovereign issuer, a Fund may suffer significant loss.

High yield bonds risk: These bonds are issued by companies or governments with lower credit ratings and as such are at greater risk of default or rating downgrades than investment grade bonds.

Contingent convertible bonds (“CoCos”): these financial instruments become loss absorbing upon certain triggering events, which could cause the permanent write-down to zero of principal investment and/or accrued interest, or a conversion to equity that may coincide with the share price of the underlying equity being low. It is possible in certain circumstances for interest payments on certain CoCos to be cancelled in full or in part by the issuer, without prior notice to bondholders.

Further explanation of the risks associated with an investment in this Fund can be found in the prospectus.

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