We see value in government bonds. Keith Balmer, portfolio manager, explains why and how our CT Universal MAP portfolios are positioned to take advantage of an anticipated shift in inflation and interest rate expectations.
While we’ve shifted slightly our overall position in government bonds between UK Gilts and US Treasuries, seeking out relative value, the portfolios continue to hold a high proportion of their assets relative to their history in government bonds. This chart shows why – government bonds now offer the highest yields in over a decade.
Enormous changes in 10 year US real rates
Yield on 10 year US inflation protected security
Source: Columbia Threadneedle Investments and Bloomberg as at 4 September 2023
Specifically, the chart is of the real yield on US Treasury Inflation Protected Securities (the US equivalent of Index-Linked Gilts) The real yield is on top of inflation and is on the most liquid and creditworthy of assets and securities. That real return is now nearly 2% – on a risk adjusted basis that looks very attractive. For context the period of zero interest rates and quantitative easing forced down real returns to -1% per annum. Even for the years preceding that crisis, the average real yield was below 1%, and we can extend that right back to 2011.
However, in addition, we see very big improvements in the drivers of inflation in the US economy that the market really hasn’t recognised. As a consequence, we expect the Fed to cut rates much earlier than people think, with our forecast of a reduction of more than 1% in 2024. Similar factors are at work in the UK. This expected shift in inflation and interest rates expectations will directly benefit capital returns from government bonds.
It’s worth noting that to get to these current attractive yields, long term holders of long-dated bonds have experienced a torrid time, especially by comparison to the period of zero interest rates and quantitative easing. For example, the Treasury 2.5% 2065 issued around £100 as a 50-year gilt in 2015 saw its price hit over £180 in 2020 before collapsing in 2022 as inflation struck, to trade around £62 now. We are positioned to benefit from the reversal of this trend as inflation falls.
Inflation in the United States surprised to the upside in August leading to a spike in government bond yields, due to an increase in expectations for the path of interest rates. However, yields at these levels, above 4.5%, look to be attractive, pointing to future gains when the current volatility subsides and expectations of interest rates starting to fall.
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