As expectations for an upturn in the economy rise, UK bonds are enduring their worst quarter in 20 years
UK government bonds have recorded their worst quarter in at least two decades, according to a Bloomberg Barclays index.
Global bond markets have had a torrid time in the opening three months of 2021, but the sell-off in gilts has been extreme, which has seen yields plummet 6.5% on a total return basis – putting it on track for the worst performance on records going back to 2000.
Demand for bonds has weakened since January as investors seem to have decided that negative rates are not on the cards for the UK, and with Brexit resolved, these removed support for gilts from many investors looking for a safeguard against uncertainty.
The picture of institutional investors shunning bonds was one portfolio institutional revealed in February.
Now an unprecedented convergence of events and economic recovery packages have generated serious concerns that inflation will eat into fixed-income returns.
And this parlous outlook could get worse. Analysts are expecting a further period of poor performance for bonds, as the so-called ‘reflation trade’ – where growth and inflation accelerate – led by US bonds, continues.
“With current yields so low, and prices across the board quite high, the chance of significant further gains is unlikely. In fact, we think it’s more likely we could see capital losses,” said Joseph Hill, investment analyst at Hargreaves Lansdowne.
It seems many investors expect reflation to look different in the EU, with the economic outlook considerably more uncertain. Many countries, including France, Italy and Germany, have recently gone back into lockdown to contain a third wave of infections.
As a result, debt issued by Germany, France, Italy and Spain have done better, with losses ranging from 0.5% to 3%.
The UK benchmark 10-year gilt yield increased 0.56% in the first quarter to 0.76% and pushed the gap between yields on UK bonds and bunds to the widest since the autumn of 2019 – at about 1.1%.
A key part of the picture is the Bank of England (BoE) upgrading its growth forecasts. A somewhat relaxed Andrew Bailey, BoE governor, said recently that the rise in gilt yields is consistent with the “change in the economic outlook”.
This seemed to present an assured narrative that the BoE will not need to cut its main policy rate below zero, instead adjusting the focus to when will be the time to raise rates from historic lows – if growth leads to stronger inflation.
This picture is in stark contrast to last year, when the debt of many countries rose as central banks around the world flooded the market with unparalleled stimulus packages at the height of the pandemic.
A difficult period for bonds is likely to be helpful for sterling and other UK assets, if, that is, the economic recovery keeps up positive expectations.
This scenario could yet be given another twist, as the current UK rosy economic outlook could well be scuppered by new Covid-19 variants or poor global growth.