Just over a week ago, many international bond investors had barely heard of Kwasi Kwarteng. But the brand new UK chancellor has crashed into a rekindling romance between asset managers and debt markets all around the world in impressive style.
In the process, Kwarteng has demonstrated how the path for central banks towards higher interest rates and lighter support for bond markets will be fraught with danger.
Before the meltdown in UK markets over the past week or so, investors were rapidly falling for the charms of an asset class that had been unusually cruel to them all year.
“Bonds are back,” proclaimed Amundi’s chief investment officer Vincent Mortier at a presentation in mid-September. “I’m convinced that bonds are back.” Debt had delivered a horrible blow to investors’ portfolios up to that point in 2022, as they were eaten up first by inflation and then by an aggressive response from central banks.
That most traditional model of investment portfolios — 60 per cent in equities and 40 per cent in (typically) boring old bonds — had failed. Data crunched by Charlie Bilello, at Compound Capital Advisors, show that a theoretical portfolio built along those lines comprising the S&P 500 and 10-year Treasuries had lost 16 per cent by September 19, a huge hit this year as both sides of the mix — stocks and bonds — fell. You have to go all the way back to 1937 to find anything that bad.
But that 60/40 split was starting to look attractive again after a long period “in the freezer”, said Mortier, as bond yields had finally risen high enough to draw in those looking for some value or a safe place to hide in the event of another economic or geopolitical shock.
This view has been taking hold elsewhere. Speaking on the eve of Kwarteng’s “mini” Budget, Jim Leaviss, chief investment officer for public fixed income at M&G Investments, noted rather presciently that you have to be “careful what you wish for” and that the UK market had some special challenges. Still, broadly, “we have moved on from a very very boring place to be as a bond investor over the past several years”, he said. “Now pretty much all areas of fixed income offer incredible value.”
Well, if bonds offered value then, they offer a lot more now. Kwarteng’s tax-cutting, debt-fuelled “mini” Budget lit a fire under the UK government bond market, sending yields racing higher at a pace that no practising fund manager had ever seen before, and leaving pension schemes facing demands for tens or even hundreds of millions of pounds in cash to keep their hedging strategies intact. How would they meet those demands? By selling gilts, of course, sending the yields higher still. It was like an Escher painting from hell.
We Britons like to tell ourselves we are terribly important. In reality, UK markets are generally a sideshow for investors elsewhere in the world. But, quickly, this spiral of doom drew in other markets.
“I work for a large US asset manager with significant fixed-income assets,” says Quentin Fitzsimmons, a senior portfolio manager at T Rowe Price. “At the start of the week we were seeing moves in US Treasuries that could only be explained by what was happening in the UK.” It is not unprecedented for the rather cutesy gilts market to move around global rates, but it is rare.
It hit closer to home too. “There was severe stress in the system,” says Christian Kopf, head of fixed income at Union Investment. “We saw it also in the euro area government bond markets. In [German government bonds]. In swap spreads. In European corporates.”
The whole experience has reinforced for Kopf that as central bank support for markets melts away, long-hidden stresses and strains come to the surface. “There’s a greater degree of fragility in the market than people realise,” he says.
Bank of America’s rates analysts called the UK “contagion nation”, and noted that out of 23 developed government bond markets, all had a rise in their 10-year yields in September. The UK leads the pack by some distance, with its benchmark yields up 1.35 percentage points over the month, roughly double the increase in Germany, for instance.
“The UK has been the epicentre of the bond crash in September ’22. Fiscal largesse by the UK Conservative party has instigated a vicious spiral in UK assets,” wrote Barnaby Martin and colleagues at the bank.
This cuts both ways; when the Bank of England stepped in with a circuit-breaking bond-buying programme, it sent gilts prices soaring. Some investors were lucky or skilful enough to catch the wave. “We came in on Wednesday morning and looked at the gilt market, and the longest inflation-linked bond was at 40p on the pound,” says Craig Inches, head of rates at Royal London Asset Management. “We bought it, and then after the Bank of England came in, sold it at 90p. We made about 150 per cent in three hours.”
The related drop in gilt yields across the board also pulled down those elsewhere around the world. Still, any fund managers who were falling for the charms of bonds now have much to thank Kwarteng for. If nothing else he has opened up some nice lower prices to snap up.