Fixed income markets are currently experiencing a rare irregularity. Short-dated bonds are trading at a higher yield than long-dated bonds, in other words, the yield curve is “inverted”. For investors in short-dated corporate bonds, this provides a unique opportunity to benefit from some of the most favourable forward looking relative return prospects and attractive valuations in recent history. What this means is the key decision for investors isn’t how much duration to take, it’s where to position on the curve.
The chart below illustrates historic inversion in the Gilt curve through the spread between 2-year and 10-year Gilts. As we saw in 2022, when inflation accelerates and the Bank of England starts to hike rates, Gilt yields usually rise. Yields at the front end often rise more than the long end in this environment as markets price in expectations for higher rates in the short term, followed by falling rates as growth slows (i.e. the curve “inverts” - see chart 3).
Chart 1: Gilt yields are currently inverted, a rare event in fixed income markets over the past 20 years
Source: Fidelity International, Bloomberg. September 2023. Indices used: GUKG10 Index, GUKG2 Index, UKBRBASE Index.
However, what happens when the reverse occurs, and the Bank of England starts to cut rates? 2-year bonds are the most impacted by any imminent shift in monetary policy as they have the highest sensitivity to near term interest rates. We saw this back in 2008, where the onset of the global financial crisis led central banks to rapidly slash their benchmark interest rates, leading to a substantial rally in the front end of the curve and a significant steepening of the spread between 2 year and 10-year yields.
Whilst short dated bonds typically rally on the back of rate cuts, long dated corporate bonds are influenced only in part by near term interest rates. Future expectations of economic growth and inflation also play a significant role in the pricing and return of these securities as these are the key determinants of future short-term rates. In 2008, for example, the realisation that rates would be close to 0% for an extended period had not yet been fully priced in. As such, the reaction of longer dated bond yields to Bank of England rate cuts was more muted than at the front end of the curve.
We have recently seen one of the fastest rate hiking cycles in history and recent UK growth data and inflation prints are tentatively indicating that its impact is starting to be felt. However, the UK economy is not out of the inflationary woods yet. Brexit and deglobalisation, amongst other supply side shocks, could leave the UK a more permanently supply constrained economy. With productivity also posing a challenge for policymakers, we could see structurally higher inflation in the UK moving forwards.
What does this mean for investors? When looking at where to add duration risk, there is much to be said for having a healthy allocation to the short end of the curve to take advantage of any yield curve steepening. The short end of the curve should rally materially on the back of any near-term rate cuts in the event of a recession providing a near-term capital gain for investors. However, moves in the long end could be more muted, particularly as investors price in concern over a structurally more inflationary UK economy.
