A little over a week ago, many international bond investors had barely heard of Kwasi Kwarteng. But the brand-new British Chancellor has impressively plunged into a rekindled romance between wealth managers and debt markets around the world.
Kwarteng has shown that the central banks’ path towards higher interest rates and less support for the bond markets will be fraught with danger.
Before the UK markets collapsed in the last week or so, investors were quickly falling for the charms of an asset class that had been unusually cruel to them all year.
“Bonds are back,” announced Vincent Mortier, Amundi’s chief investment officer, at a presentation in mid-September. “I am convinced that bonds are back.” Debt had dealt a terrible blow to investors’ portfolios by this point in 2022, being eaten up first by inflation and then by an aggressive response from central banks.
The most traditional model of investment portfolios – 60 percent in stocks and 40 percent in (usually) boring old bonds – had failed. Data compiled by Charlie Bilello at Compound Capital Advisors shows that a theoretical portfolio constructed according to these principles, comprising the S&P 500 and 10-year Treasuries, was down 16 percent as of September 19, a major 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 this bad.
But that 60/40 split was starting to look attractive again after a long time “in the freezer,” Mortier said, as bond yields had finally risen high enough to lure those looking for some value or a safe place to hide their money case were looking for another economic or geopolitical shock.
This view has prevailed elsewhere. On the eve of Kwarteng’s “mini” budget, Jim Leaviss, chief investment officer for public bonds at M&G Investments, said rather presciently that you have to “be careful what you wish for” and that the UK market has some particular challenges. Still, broadly speaking, “we’ve gone from a very, very boring place as a bond investor over the last few years,” he said. “Today, pretty much every area of the fixed income space offers incredible value.”
Well, if bonds offered value then, they offer much more now. Kwarteng’s tax-cutting, debt-fueled “mini” budget sparked a fire under the UK government bond market, sending yields rising at a rate no practicing fund manager had ever seen before and placing tens or even hundreds of demands on pension schemes millions of pounds in cash to keep their hedging strategies intact. How would you meet these requirements? Of course, selling gilts drives yields even higher. It was like an Escher painting from Hell.
We Brits like to tell ourselves that we are incredibly important. In reality, the UK markets are generally a sideshow for investors in other parts of the world. But this spiral of doom quickly attracted other markets.
“I work for a large US money manager with significant fixed income assets,” said Quentin Fitzsimmons, senior portfolio manager at T Rowe Price. “Earlier in the week we saw moves in US Treasuries that could only be explained by what was happening in the UK.” It’s not unprecedented for the rather cute gilt market to move around global rates, but it’s rare.
It also hit closer to home. “The system was heavily loaded,” says Christian Kopf, Head of Fixed Income at Union Investment. “We’ve also seen it in eurozone government bond markets. in the [German government bonds]. In swap spreads. In European companies.”
The whole experience has reinforced for Kopf that long-hidden tensions and strains will surface as central bank support for markets melts away. “The market is much more fragile than you think,” he says.
Bank of America interest rate analysts dubbed the UK a “contagious nation” and noted that out of 23 developed government bond markets all saw their 10-year yields rise in September. The UK leads the field by some distance, with its benchmark yields up 1.35 percentage points over the month, about twice as much as Germany, for example.
“Britain was the epicenter of the September 22 bond crash. The fiscal largesse of the British Conservative Party has triggered a vicious spiral in British assets,” wrote Barnaby Martin and colleagues at the bank.
This goes both ways; When the Bank of England stepped in with a groundbreaking bond-buying program, gilt prices soared. A few investors were lucky or savvy enough to catch the wave. “We came in on Wednesday morning and looked at the gilt market and the longest inflation-linked bond was 40p for 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 we sold it for 90p. We did about 150 percent in three hours.”
The associated fall in gilt yields across the board also dragged those elsewhere around the world. Still, all fund managers who fell for the charm of bonds now have a lot to thank Kwarteng for. If nothing else, he’s opened up some nice lower prizes to snap up.
https://www.ft.com/content/7e0f2620-4de6-4206-b1c5-a3018aee0ac4 Kwasi Kwarteng crashes while love-in in the bond market