Market Update & Commentary

After a volatile seven weeks on global markets equities have been rising steadily. The FTSE 100 hit a recent low of 6,029 on 24th June; yesterday it closed at 6,505. I sense the improving confidence has come from positive economic data, a focus on fundamentals and a realisation that a stampede to the exit by investors on news of tapering of QE in the States was overdone. Notwithstanding this return to objectivity, bond yields have increased. Benchmark US 10 year Treasuries yielded 1.63% p.a. on 2/5/13. Nearly two months on they have risen to 2.64% p.a. Gilt yields have also risen significantly. To remind you bond yields are inversely related to bond prices – so if prices fall, yields rise and vice versa.

Like a junkie the bond market did not take kindly to the expectation of withdrawal of its regular fix – money printing and asset purchases. QE has been highly supportive of high bond prices and hence very low yields although this has been in the wider context of a 30 year bond bull market driven by falling global inflation. There is a widespread view that despite the recent falls, bonds are still overpriced, yield suppression cannot last for ever and fixed interest investments including government bonds and corporate bonds are liable to a sharp correction. The last major bond sell off was in 1994 when unexpected US interest rate rises sent prices tumbling.

So what are the consequences of rising bond yields? Firstly it costs governments more to fund future borrowing. This has been particularly relevant for EuroZone economies such as Italy and Spain but could affect the US, the UK and Japan, the latter in particular has very high levels of public debt. This impacts government spending and taxation. Secondly high bond yields cause interest rates to rise on cash, as banks have to compete for income investors; with higher bond yields now attracting more money. This feeds through to higher mortgage interest rates, a recent phenomenon emerging in the US. This dampens housing demand and prices and increases the costs of servicing existing mortgages impacting on household budgets and consumer confidence. A third negative factor is that investors will rotate from equities to fixed interest to buy bonds with attractive yields.

In short a bond sell off could be ugly. Fortunately managers of high quality actively managed bond funds are aware of the risks and have positioned their portfolios in a variety of ways. Defensive measures include reducing “duration risk. ” This is the sensitivity of a bond portfolio to rising interest rates. Duration can be reduced by buying short dated bonds or high yield corporates, whose prices are more affected by credit risk than interest rate risk. Managers can also short government bond indexes through the use of futures. For income investors I favour truly flexible strategic bond fund managers who can invest in a diverse range of fixed interest asset classes.

In conclusion although we are in calmer waters now expect further ructions in bond and equity markets in the near future. Longer term there are signs of economic recovery and growth including in the UK and I remain broadly positive on equities.

To finish there are some positives from rising bond yields. One is improving annuity rates. Something to consider if you have uncrystallised pension plans. The second benefit is higher yielding bond funds for income investors as noted above. Combined with the tax benefits of an ISA, where a plan manager can reclaim 20% tax on interest from qualifying bonds this is a potentially good long term investment choice.

You should seek financial advice before making investment decisions.