Sovereign bond values are most affected by increasing interest rates because they usually have lower coupons and greater maturities than corporate debt. It is no surprise, then, that developed government bonds have performed poorly as anticipation mounts of increasing US interest rates.
Year to date, gilts and US treasuries have lost 2.5% and 0.1%, respectively, compared with a 6.1% gain for the FTSE All-Share Index and a positive 3.2% return for the S&P 500 Index.
That is a complete reversal of 2014, when tightening yields pushed gilts to perform strongly against the FTSE All-Share Index, which made a paltry 1.2%.
The Barclays Sterling Gilts index rose by a staggering 14.6% over the year, outstripping even the S&P 500’s 13% gain.
An eye on the US
As market consensus has hardened around an interest rate rise in the US toward the end of the year, bond yields have started to widen again. European bonds and gilt yields had been trading much lower than US debt, which made for larger capital losses as sentiment began to turn.
Take the 10-year bund as a case in point: it rose from a record low yield of 0.05% in April to 0.84% by mid-July.
Despite this, I do not believe sovereign bonds are facing the death knell just yet.
That is because they offer the lowest possible credit risk. Besides cash, quality sovereigns still provide the safest and most liquid store of value available. They have a place in portfolios for that reason.
In addition, government debt is inversely correlated to equities: if equity markets are rattled by macroeconomics or geopolitics, one can expect these bonds to rally.
The liquidity of gilts and treasuries typically remains high, unlike low-grade credit, which is already making many investors nervous of a liquidity crunch. All things considered, I believe government bonds currently offer the cheapest form of portfolio insurance.
Where this view does not bear out, however, is in the debt of emerging market nations. The redeeming features of sovereign emerging market debt are not sufficient to offset the tide of US monetary policy, something that has never worked out well for the asset class in the past.
