15 years of change in government bond and cash markets

Royal London Asset Management’s Head of Rates & Cash, Craig Inches, celebrated 15 years with us in January 2024. He talked us through what has changed – and what hasn’t.

What has really stuck with you in terms of how you manage funds?

Looking back on my time managing portfolios, I think that age plays a big role in how you like to look at markets. If you were managing government bond portfolios before the global financial crisis (GFC), fundamentals were one of the main drivers of your process. The assumption of a ‘neutral’ base rate would be based upon GDP growth + inflation – so in the UK for instance at the time, roughly 2% per annum GDP growth, plus a 2% inflation target meant that neutral base rates should gravitate towards 4%, and operate in a range around that of perhaps 3-5%. That would translate to your ‘risk-free’ two-year gilt yield and if the market thought the economy was running hot (and rates would need to rise), you would see an upward sloping curve, and vice versa.

Technical factors, such as pension fund buying were looked at, but these were more incidental: perhaps leading to small ‘kinks’ in the curve at certain points. That was, until the GFC. The introduction of quantitative easing (QE) was the proverbial game-changer. In the UK, it meant fundamentals were almost irrelevant: you had a huge buyer who was insensitive to price and had unlimited funds. Looking at fundamentals probably made life harder – you would have areas of the market that looked terrible value, but if the bank was likely to buy more there, you did too.

With the end of QE, we’ve gone full circle, and fundamentals matter again. I think that gives managers with experience of that pre-GFC environment an advantage – if you started your investment career after 2008 you’ve spent your career in a technical-driven world. That doesn’t preclude newer managers doing well, but I do think that that having a few more grey hairs can help.

What do you see as a key difference in how you do things?

As well as the fundamentals point, being active is another essential part of our success. It’s easy to think that gilts are these efficient markets. They’re not. Take a look at the UK 10-year gilt yield. Two years ago it was about 1%. Today it’s about 4%. But the line from 1% to 4% is far from straight. Now of course, gilts are efficient in that information clears quickly – at least now that QE is not distorting things. But the consensus view of where inflation, growth and rates are going constantly overshoots. I think there are lots of opportunities to take advantage of against that consensus view.

“It’s easy to think that gilts are these efficient markets.They’re not.”

Let me give you an example from last year. In the first half of last year, consensus said the bank was near a peak in rates at 4-4.5%. We felt that was too dovish, and went short – sure enough, inflation proved stickier than thought, and the consensus swung quickly to price in peak rates at around 6%. This seemed madness to us – yes inflation was sticky, but there were signs it was starting to come down. So we went long. Sure enough, inflation came down, we got one or two unexpectedly low prints and the market is now pricing in four or more cuts in 2024 and yields drop like a stone. But again, we felt it was overshooting – the only way the bank cuts four times is if there is a large recession or inflation is below target – there’s no sign of that yet.

With that volatility, a single strategic duration stance may eventually result in a nice return but could provide a lot of anxiety along the way as the market moves this way and that. I prefer to take smaller incremental active positions around a longer-term theme. This uses that volatility for our clients’ benefit, rather than putting them through large swings in performance.

How does your approach change for cash funds?

On one level, it doesn’t. We manage liquidity or cash funds in the same way as we would manage a fixed income fund – with fundamentals a foundational aspect of the approach, but then tweak it to allow for credit and the shorter-dated nature of the market.

Traditionally, cash funds were often run by a separate team. And the approach was somewhat mechanical – sift the banking universe to weed out those with a short-term rating of lower than A1/P1/F1 – be mindful of UCITS rules on concentration – look at best rate at each maturity point and fill those ‘buckets’ with best rate available at each point. That worked until the GFC, when really understanding your counterparty banks became extremely important.

“From a fundamental point of view, we take that assessment of interest rates and what the market is pricing or mispricing, and add a credit risk assessment on top.”

I’ve always seen the overlap between rates and cash markets because both price off base rates. For cash or liquidity type strategies, the curve is shorter, and the range of instruments you can use is wider, but both have this same pivot point, and assessing how the market is looking at that pivot point is vital.

So from a fundamental point of view, we take that assessment of interest rates and what the market is pricing or mispricing, and add a credit risk assessment on top. We look at credit risk from an issuer point of view – so is bank A more robust than bank B, but also from an instrument basis, using certificates of deposit, covered bonds, short-dated senior bank bonds on top of overnight deposits, repo, treasury bills and gilts. The latter are sometimes overlooked in liquidity funds, but definitely have a place. During Covid, these were very useful for maintaining the duration / liquidity profile of some of our funds while stripping out credit risk in an environment where no-one initially knew what lockdowns would mean for company revenues and profits.

What have you changed?

There are two areas where I’ve adapted to changing market demands. Learning not to be wedded to positions is the first. The second is ESG and how this is reflected in my portfolios.

The positioning point reflects changing markets and ties into that point I made about wanting to be more active. I think that 15 years ago, I could take larger positions and probably hold them for longer too. One reason for that was the make-up of the market itself – a large proportion of gilt market activity was driven by asset managers like us, or pension funds with a similar macro focus or technical themes. Following the GFC, we had that price insensitive buyer (the Bank of England) but just as importantly, the pension buyer in the market had become more leveraged and was also accompanied by leveraged short-term hedge fund activity trading off micro and macro views, and the impact of herd views is that those moves can swing quite far one way or the other. If we take large positions and you’re on the wrong side of one of those moves, it can feel very uncomfortable for our clients.

“There are two areas where I’ve adapted to changing market demands. Learning not to be wedded to positions is the first. The second is ESG.”

ESG factors have definitely become more apparent. In my world, this is more applicable to cash than rates – although even in the rates world, we are seeing interest from clients in using an investment universe that weighs countries with better ESG characteristics more highly. But it is more apparent in cash. We are placing money with banks and we feel that understanding the ESG characteristics of a bank is just as helpful as understanding its balance sheet. We use a number of quantitative screening measures to score each bank in the universe. That score, and the nature of it, will determine how we act. With some banks, we will simply not invest – Credit Suisse and Silicon Valley Bank were good examples last year where governance and social concerns meant we avoided these. With some poorly ESG rated banks, we may continue to use them, but that will be alongside engagement to try to address the issues of concern, and / or we will likely invest only in short maturities until we see a material improvement – for instance by keeping deposits sub three months maturity this gives us the ‘backstop’ of knowing that if any issues do emerge, we get our money back in relatively short order.

Another way to think about ESG is in terms of key priorities for cash investors: security, liquidity and yield. A bank that has an ESG ‘event’ will immediately see impaired liquidity in longer-dated paper and we try to avoid that.

What are you looking at and looking out for in 2024 and beyond?

Turning points are always interesting. At the end of 2023, markets moved to price in a lot of rate cuts. Then reversed a lot of that in the first 10 days or so of 2024. I think that with inflation still high – particularly wage inflation – and other indicators such as service Purchasing Managers’ Index looking okay, the impetus for central banks to start cutting at pace is just not there. So if we look at the UK, while the market has had rates coming as low as 3-4% this year, I think that there will be cuts but much fewer than expected.

Against that, what am I being paid to own? You can still build portfolios of short-dated assets yielding 5% or more – so that is very little interest rate risk and relatively low credit risk too. That is quite a hurdle to clear if you’re thinking of investing in equities or longer dated bonds. Of course, if rates do fall, that level of yield will come down too, but we have to think what falling interest rates implies – falling inflation but also weak or even negative growth. Equities may initially like lower rates, but a poor growth outlook or recession isn’t terrific for that asset class. If you think that the economy is in trouble, and that rates are coming down a lot, then sovereign bonds would be a great home – but again, is that a realistic scenario? Don’t forget that government bond markets are going to see a lot of supply this year, in the order of $2.5 trillion, and we no longer have those price insensitive buyers to mop that up. So in my view, is having an allocation to cash or cash equivalents still sensible? I think it is – at least until there is a bit more clarity.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.