A bond market sell-off in late February 2021 spooked equity investors to also push stock markets down across the board. Frequent followers will note we have been ‘negative’ for fixed rate bonds for around a year now. The ‘science’: A bond is a loan to either a government (gilts and sovereign bonds) or to a large company (corporate bonds).
Most bonds are fixed income stocks. This means that the income is fixed and capital values rise if interest rates fall and capital values fall when inflation rises and pressure to increase interest rates increases.
We have seen policy statements from both the US Federal Reserve and the Bank of England that the Fed plans to no longer control inflation with interest rates ‘for the foreseeable future’ and the Treasury in UK i.e. the Chancellor, suggesting that he will revisit how RPI is calculated in a few years time meaning they expect higher inflation.
In short, central banks and governments are planning/pushing for higher inflation to devalue public sector debt without ever repaying it. Inflation and interest rates are key drivers and whilst our expectation in the UK was for interest rates to go negative in the short term (which theoretically will push fixed rate bonds higher), the EU, Japan and others are already in negative rates. Long term we have been and are betting on inflation and then higher interest rates. This will drive fixed rate bonds down and index linked bonds/gilts up.
The bond market sell off has come earlier than expected by us. The problem is that if professional investors and institutional investors are already geared up in the bond market e.g. if you invest £10 and have a x 10 gearing = £100 market exposure, if the bond market falls by just 3% and you have £100 market exposure (£10 x 10), this means you have lost £3. That said, because you are geared x 10, you were only worth £10 originally but have now lost £3, that’s a 30% loss. Losses like this in the bond market then force geared investors to sell off their equities to cover bond market losses.
This was the exact cause of the Black Monday Crash on 19th October 1987. That said, we are expecting economic stimulus over the coming months so we maintain our position of full exposure to stock markets to benefit from any stimulus and recovery, we remain negative for bonds/fixed interest and positive for index linked bond funds and equities.