The thing that will hit hard in a recessionary environment is the spread. It does not matter what the gilt is, the spread will widen. Remember: if yields go up, bond prices will fall — but you are being compensated for this risk at these elevated yields.
One of the main underlying reasons for inflation remaining high is goods inflation, which has continued to creep up. The employment market is also strong, promoting wage inflation as well.
Snowden says estimates indicate that inflation will be in the region of 3 to 4 per cent in the next 10 years. That scenario makes corporate bonds incredibly attractive as you will get a decent yield now and if those rates go down, bonds will rise and you will get a capital uplift.
Liontrust Sustainable Future Monthly Income Bond fund co-manager Jack Willis says there is a real risk that the UK falls into recession in the coming months and consensus forecasts, while upgraded so far this year, are still for muted growth over the next few years.
He adds that following recent stronger-than-expected inflation data, markets have priced in several further hikes, taking the market-derived peak in base rates to 6 per cent or higher. But with the economic growth outlook anaemic and inflation likely to fall back belatedly towards the Bank of England’s 2 per cent target next year, the case for further rate increases is limited.
“The bond market is currently very focused on short-term trends in macroeconomic data, such as inflation prints, as it attempts to call the peak in base rates, so we expect more volatility over the course of this year as sentiment fluctuates,” Willis says.
“But we think long-term investors should view this short-term noise as a mispricing opportunity — with base rates close to peaking, we think current UK government bond yields of 4.4 per cent (10-year bonds) are very attractive.”
Dispersion opens the door to active
The last point I want to highlight is that this is a good time to take the active management route for investment-grade bonds. There is currently a deluge of gilt issuance in the market during this inflationary backdrop (around £277bn for financial year 2023-24) as this is now a quantitative tightening scenario — the Bank of England is adding rather than buying the supply. There is plenty of choice around for managers.
In addition to the greater supply, Snowden says the end of QE has created greater dispersion in investment-grade bonds. He says: “During 2008, you had bank bonds trading at 10p to 30p in the pound, whereas utility/telecom bonds were being treated like royalty. Bonds were either incredibly cheap or expensive — very few bonds traded at the average level.
