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Bonds away – look elsewhere for protection from equity volatility

15 Mar 2021

This time last year, markets were in the grip of the coronavirus crisis. Stock markets were tanking and central banks were embarking on aggressive interest rate cuts and other stimulus measures to steady the financial system.

It all sent bond prices rocketing, pushing yields to rock-bottom levels. Now, the issue for investors is that those bond prices have been falling back and yields are rising. Some hedge funds are raking in big returns. But other institutional investors are fretting that it could yet seriously destabilise markets.

So what’s going on?

In short: inflation. Serious consumer price rises themselves are not here yet — the global economy is still only tentatively creeping out of its coronavirus hibernation. But investors have good reason to think it could start to bite. Commodity prices have already shot higher in anticipation of a global economic recovery. Copper has hit its highest price point in a decade. Oil is back above $60 per barrel, having wiped out the coronavirus shock. Companies in the US and elsewhere are reporting shortages of goods and rising costs for raw materials. It all looks like a recipe for consumer price rises.

This isn’t good news for bond holdings. By any sensible historical measure, bond prices are still sky high, thanks to the vast monetary stimulus launched by central banks seeking to soften the blow of the pandemic. But the pullback at the start of 2021 has been fierce as investors try to price in inflation before it happens. It is the worst start to a year in bonds since 2015. When bond prices fall, yields rise.

In the US, 10-year yields have pierced 1.5% for the first time since the pandemic struck, with a particularly wild day’s trading on February 25. The UK, which not so long ago was flirting with cutting interest rates below zero, has seen a rapid rise in yields to around 0.8%. On top of this, the Budget revealed government plans to borrow even more than banks had previously expected. The classic split for an investment portfolio is 60% equities, 40% bonds. The premise is that as one asset class falls, the other usually rises. But this orthodoxy has been looking shaky for years, as yields have sunk so low that they offer little scope for further gains if stocks take a knock. HSBC believes the UK government bond market is exaggerating the risk of a rise in interest rates from the Bank of England, but it warns clients to buckle up for a “choppy ride” in gilts.