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For the past 40 years or so, bond investors have, in a sense, been spoiled by an almost continuous fall in yields from over 14% in the 1980s, which – as bond prices move in the opposite direction to yields – resulted in strong capital gains in addition to the income received. That may have felt good at the time, but each time yields fell it simply reduced the future returns from bonds from that point forwards.  UK 5-year gilt yields, for example, eventually reached a point – 0% – where they delivered no expected return at all, even before inflation was taken into account.  The insurance premium for owning high quality bonds to balance a portfolio against equity market falls was very high, but there was not much one could do to avoid this.

If you ask any investor if they would like higher or lower returns in the future the answer is a given.  Today the Bank of England’s base rate is only 0.75%.   Fortunately, short-dated, high-quality bonds in a number of major markets are now yielding in the region of 1.5% to 2.5% as yields have risen quite substantially over the past few weeks, as markets have begun to reflect the risks of higher-for-longer inflation.  The chart below shows what has happened to various global bond yields since the end of 2020. Going forwards that is a good thing.

Figure 1: Bond yields have been rising fast

Data source: UK – Bank of England, US – Federal Reserve, Australia – Reserve Bank of Australia

Unavoidably, the short-term cost of attaining higher yields is small capital losses on shorter-dated bonds.  These should be viewed in the context of the potential downside of equities at times of poor markets and other bond alternatives.  For a longer-term investor this should be seen as a price worth paying for higher future returns.

To illustrate the point, imagine that you bought a bond yielding 1% a few weeks ago, but yields demanded by investors to own these bonds have now risen to 3%. If you wanted to sell your bond no-one would buy it at a 1% yield, but you might find a buyer if you dropped your price, thus raising their yield.  Markets work pretty well and once its price fell to deliver a yield of 3%, you would start getting bids.

Although you suffered a capital loss[1], your bonds now have a higher yield going forward, which will compensate you for this loss over time[2] and deliver a higher return thereafter.  That is a good thing for any longer-term investor.

The news potentially gets better.  Today, there is quite a steep difference between cash rates and five-year bonds in some markets.  As a hypothetical example, if you hold a five-year bond for a year, it becomes a four-year bond, and its yield will reduce. We also know that yield falls lead to price rises.  So, our expected return from owning bonds will therefore be the sum of the yield-to-maturity on the bonds held plus any capital gain that might arise from a steep bond yield curve (this is known in the bond world as ‘roll-down yield’). Note though that there are no guarantees that this extra return will be collected as market yield movements, which are random in nature, may change the picture.

It is also worth noting that the yield rise impact has been materially less severe in high quality, shorter-dated bonds than for longer-dated and lower quality bonds, as the chart below illustrates.

Figure 2: Longer-dated and lower quality bonds have taken more pain in 2022

Source: YTD to 30-3-2022.  Various ETFs (see endnote). * = hedged to GBP

In reality, no one knows if yields will rise again, stay the same or fall. Remember that if there was any certainty in which direction yields should move, they would already have moved!  If they do rise again, owners of bonds will take a bit more pain, but they will end up in an even better place with yet higher expected future returns. Patience and a long-term view are required.

No pain, no gain.

Risk warnings

This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy, or investment product.  Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

Endnote – Figure 2 data series:

iShares UK Gilts 0-5yr ETF GBP Dist., iShares £ Corp Bond 0-5yr ETF GBP Dist., iShares Global HY Corp Bd ETF GBP H Dist., iShares Global Corp Bond ETF GBP H Dist., iShares Core UK Gilts ETF GBP Dist., iShares £ Index-Lnkd Gilts ETF GBP Dist., iShares JP Morgan $ EM Bd ETF GBP H Dist.

[1] The actual amount of the loss is equivalent to the duration of the bonds multiplied by the rise in yields e.g. 3 year bonds with a 1% yield rise will fall by 3%.  Duration is similar to the maturity of the bonds.

[2] In practice, the time it takes to recoup these losses and begin to benefit from the higher yields is equivalent to the duration of your bond portfolio.  Short-dated bonds take less time than longer-dated bonds to start benefitting from higher yields.

Pacem is delighted to continue its support of an initiative entitled ‘Spare Room to Stellar‘, alongside Belfast City Council and Danske Bank. Spare room to stellar is designed to inspire and equip Belfast entrepreneurs to start and grow a business. It does this by firstly sharing the stories and lessons of businesses that started in a spare room in Belfast and have gone on to compete, and win, on a global scale.

The second film released in the 2022 series is that of Lynsey Bennett and Lusso Tan. Hear how Lynsey started her ever-expanding, revolutionary tanning brand providing inspiration and tips for early-stage businesses and entrepreneurs alike.

Watch the highs, lows, habits and how-tos of starting/growing a business from humble beginnings. Sit back, enjoy and then act on your idea or early venture by booking a signposting consultation over at www.spareroomtostellar.com 

You can watch the Lusso Tan story here:

National Insurance Contributions (NICs)
Despite lobbying to delay the upcoming 1.25% increase in NICs payable by employees, employers and the self-employed, the government has decided to go ahead as planned from April 2022, to provide additional funds for health and social care.

Increase in the starting NIC threshold for individuals
The annual level at which employees and the self-employed start to pay NICs was due to increase from £9,568 to £9,880 from 6 April 2022. This increase will go ahead but be further uplifted to £12,570 from 6 July 2022, effectively aligning the point at which an individual starts to pay NICs with the £12,570 income tax personal allowance. In the tax year to 5 April 2023, this is a NIC cut worth £267 for most employees and £207 for most self-employed individuals.

Class 2 NIC liabilities of the self-employed
For the self-employed, some individuals will find that they no longer need to pay Class 2 NICs from April 2022. The small profits threshold will be set at £6,725 as planned but the requirement to pay Class 2 NIC will only apply to those with self-employed profits over £11,908. This will benefit approximately 500,000 self-employed individuals by saving them £165 a year.

• From 6 April 2023, Class 2 NIC will only be payable by those with profits over £12,570.

Income Tax
The Chancellor has committed to reduce the basic rate of income tax from 20% to 19%, but not until 6 April 2024. It is estimated that this will save 30 million individuals an average of £175 per year.

VAT Rates in the Leisure and Hospitality Sector
No extension has been granted to the leisure and hospitality sector for use of the reduced 12.5% VAT rate on eligible supplies including food, non-alcoholic beverages and hotel and holiday accommodation. The VAT rate applied to these supplies will revert to 20% from 1 April 2022 as planned.

Fuel Duty
Fuel duty has been cut by 5p per litre for 12 months from 6pm on 23 March 2022. The Treasury report that this will save the average car driver £100 a year and the average van driver £200 a year.

Sometimes as an investor we come face to face with a stark reality.  Today, that is the case with the bonds held in portfolios. By and large, most long-term investors own bonds because they do not have the emotional or financial capacity to suffer material falls in the value of their portfolio. By and large, high quality bonds have done the job asked of them delivering protection from the large equity market falls in 2000-2003, 2007-2009 and Q1 2020.  The return penalty of giving up equities to own bonds has been softened to some extent by positive returns in the past.

In December 1981 the yield on 5 year UK gilts stood at 15.5%.  What would investors give today for such yields! The next 40 years proved to be good for bond holders as governments around the world got a grip on inflation and yields fell, delivering capital gains (bond prices rise as yields fall and vice versa) on top of the income delivered in the form of bond coupons (interest payments). Gilt yields fell from these lofty heights to a low of -0.06% in December 2020. Today, 5 year gilts yields have risen to around 1% (before inflation), which has resulted in small capital losses.

With current levels of inflation being well above the Bank of England’s target rate of 2%, bond (and bank deposit) holders face the real risk of the erosion of their purchasing power.  In the presence of low yields well below inflation, and with the risk of rising yields – although no-one knows where yields will go from here – bonds seem unattractive from a return perspective going forwards.

So what’s to be done?
Investors have to ask themselves a tough question: ‘If I cannot cope emotionally or financially with suffering large equity market falls, what could I own instead if I abandon my high quality bonds’. Some investors have chased bonds with higher yields such as those issued by weak companies (high yield bonds) or those of emerging economies (including Russia), but this simply adds equity-like risk into the portfolio and dramatically reduces the defensive qualities of owning bonds.  During the equity market falls of the Credit Crisis of 2007-2009 global high yield bonds fell by around 20% and during the Covid-induced fall in Q1 2020 they fell by around 15%[1].

High cost, opaque and highly complex, absolute return strategies, relying on manager skill alone, have hardly lived up to their name.  Their sector average return during the equity market fall of Q1 2020 was down 8% or so[2].

The stark reality is that there are no easy answers, but there are a few useful points to remember:

• The return give-up of owning high quality bonds over equities should be thought of as an insurance premium. Today that premium is high. That is how the market is pricing it.  Pay the premium or surrender the policy.
• Own bonds in your portfolio to a level that satisfies your emotional and financial ability to suffer equity market falls and no more. This is something that your adviser can talk you through. How much insurance cover do you need?
• High-quality bonds still have the ability to provide down-side protection and portfolio liquidity; two qualities not to be sniffed at.
• Accept slim pickings from bonds given such low yields and in the face of inflation. There is nothing you can do about it.
• Accept that there are no easy alternatives. All carry material trade-offs and risks.
• Think of your investment pot in its entirety and avoid the trap of focusing in on one line on your portfolio valuation and pointing an accusing finger at your bonds.
• Don’t get caught up with trying to second guess whether high quality, short-dated bonds or cash are likely to be the better option over the short or longer term. No-one knows and, when compared to the high volatility that equity markets exhibit, the two are pretty similar.

Figure 1: Compared to equities, high quality short-dated bonds and cash are quite similar

Data source: IA Standard Money Market sector average – IA, iShares Core MSCI World UCITS ETF Acc. GBP in GB, iShares UK Gilts 0-5yr UCITS ETF 0 5 GBP TR in GB – iShares.

It is never comfortable confronting a tough reality but understanding that reality and recognising that the alternatives are limited, can help you to deal with it in a rational way.

If you have any questions, thoughts or actions relating to the content of this article please get in touch with us by calling us on 028 9099 6948 or by emailing info@pacem-advisory.com

Risk warnings

This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy, or investment product.  Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

[1] IA Global High Yield Bond sector average

[2] IA Targeted Absolute Return sector average.

Pacem is delighted to continue its support of an initiative entitled ‘Spare Room to Stellar‘, alongside Belfast City Council and Danske Bank. Spare room to stellar is designed to inspire and equip Belfast entrepreneurs to start and grow a business. It does this by firstly sharing the stories and lessons of businesses that started in a spare room in Belfast and have gone on to compete, and win, on a global scale.

The first film released in the 2022 series is that of David Johnston and OutsideIn.

David Johnston of OutsideIn says: “I started off with nothing but a vision and a passion to help those less fortunate. OutsideIn is now a one of the UK’s fastest growing streetwear brands and through our ‘wear one share one’ model, every time a customer purchases an item, an additional item is given to someone experiencing homelessness.

“If sharing my story inspires others to give their business idea a go, I’ll be delighted. Taking a small idea and growing it is what the Spare Room to Stellar resource is all about. After all, I started my business in my mum’s spare room too!  There’s fantastic support available for people starting out on their own in business – and we want to see more people getting out there and giving it a shot.”

In the coming weeks, people will also hear how Lynsey Bennett, co-founder of Lusso tan started her ever-expanding, revolutionary tanning brand providing inspiration and tips for early-stage businesses and entrepreneurs alike.

Watch the highs, lows, habits and how-tos of starting/growing a business from humble beginnings. Sit back, enjoy and then act on your idea or early venture by booking a signposting consultation over at www.spareroomtostellar.com 

You can watch the OutsideIn story here:

Today, it certainly feels like the world is in a very uncertain place.  Authoritarian states are flexing their muscles, with Russia violating Ukraine’s sovereignty and China’s ongoing subjugation of Hong Kong with the new National Security Law alongside its apparent support for Russia, being cases in point.

The West continues to struggle with what is hopefully the back-end of the Covid crisis as populations gather immunity through vaccination and infection, and as new drugs and treatments come online almost daily.  Economically, the greatest challenge is soaring inflation, hitting levels not seen for several decades.  As a consequence, interest rates and yields on bonds have started to rise and global equity markets have started the year down.  That can all feel both gloomy and unsettling.

It is always easy to feel that the present is more uncertain than the past.  We have all but forgotten the Armageddon scenarios of events such as the Y2K software bug issues of 2000 (planes expected to fall out of the sky, nuclear power stations potentially out of control etc.), the emotional and geopolitical impact of 9/11, or the fear many felt in 2008 when Lehman Brothers failed and the meltdown of the financial system was a real risk.

The chart below illustrates that over the mid- to longer-term the markets absorb the consequences of such events and power forwards as capitalism drives the relentless pursuit of profit opportunities.

Figure 1:  Material global event are ever present

Data source: Vanguard Global Stock Index ACC, 4/8/1998 to 14/2/2022 in GBP used as proxy for the performance of global equities. Its use in this chart does not constitute any form of recommendation and is provided for educational purposes only.

Being shaken out of markets based on today’s news is about the worst mistake any long-term investor can make.

What is to be done about the Ukraine situation?
The short answer is ‘not much’. As ever, all the news that we see and worry about – including the invasion of Ukraine by Russia – is already reflected in market prices. New news, as it develops, will have an influence on those prices, but by its very definition this is a random process that is hard to benefit from unless you own a crystal ball. It is likely that markets will be volatile as events develop. The US market actually rose on the day Russia invaded.

In terms of direct portfolio exposure it is worth noting that Russia represents around 0.35% of global equity markets, and that is before this is diluted down in any portfolio by bond holdings. To put this in perspective, the global market weight of Apple is over 4%! In fact, Apple’s cash reserves alone are of a broadly similar magnitude to Russia’s entire market capitalisation.

No-one has any real idea as to the wider impact of a Russian invasion, but even if markets fall, you need to ask yourself the following questions:

• Do you understand that equity markets can go down – sometimes materially – as part of their journey to delivering positive longer-term returns after inflation? If this is a surprise to you, then you need to speak with (or possibly fire!) your adviser.
• Have your financial and personal circumstances changed recently to such an extent that you need immediate liquidity from your equity positions? That is most unlikely. Feeling uncertain about markets is not a valid reason for seeking to get out of markets.
• Do you remember that your high-quality bonds provide several valuable attributes?
  They provide more stable values, supporting a portfolio against equity market falls; liquidity to meet any liabilities without having to sell equities when they are down; and the dry powder to rebalance the portfolio and buy more equities when they have fallen to get the portfolio back up to the right level of risk.

One piece of advice would be to try not to look at the news too much. It can feel unsettling and is increasingly full of sensationalist speculation and hyperbole. Instead, perhaps take a look at a news site that tries to balance out the regular news with positive news stories which tend to be underreported www.goodnewsnetwork.org/category/news/

Risk warnings

This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy, or investment product.  Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

Inflation measures the general increase in the price of goods and services. Left unchecked, it can be a dangerous foe to the long-term investor, eroding the purchasing power of one’s hard-earned cash over time. Since the COVID-19 pandemic began, inflation numbers have frequented the headlines. Financial stimulus around the globe has meant that more money circulating in the economy is chasing a similar (or fewer) number of goods and services, resulting in price increases.

The table below shows the latest annual inflation figures from around the globe, measured using the consumer price indexes (CPI)[1]. Most countries have not seen numbers this high since the early 90’s[2]. Using the rule of 72, one can get a sense of how quickly purchasing power halves at these higher-than-average rates[3].

Table 1: Annual inflation rates by region (2021)

Source: Koyfin © All rights reserved. Inflation measured using Consumer Price Index of each country.

Contrary to its negative implications, the consensus of economists has shifted over the years, the modern position being that a small amount of annual inflation is, in fact, desirable[4]. The Bank of England, for example, targets an annual inflation rate of 2%[5]. Primarily, this is to avoid an alternative scenario where prices are falling each year and consumers are encouraged not to spend at all, but to wait until prices fall further. The danger with a deflationary environment is that it is very hard cycle to get out of, price falls tend to lead to further price falls – just ask Japan!

Although the inflation rate is generally thought of as a single number, the consumer price index in the UK is measured using around 180,000 different prices across 720 different goods and services each month[6]. What is more, the ‘shopping basket’ is weighted using estimates of the average UK consumer, which is updated each year depending on spending patterns. This is a valid criticism of CPI indexes, as they do not account for substitutions of expensive products for less expensive ones[7]. The chart below shows a breakdown of the December 2021 inflation figure and the contribution of each basket of goods or services to the overall number. Around half of the 5.4% came from increases in transport and energy prices, whereas healthcare and communication services had negligible impact.

Figure 1: UK inflation contribution by division (2021)

Data source: ONS (2022)

The reality of the chart above is that, whilst it provides a reasonable estimate for the average consumer, everyone is subject to their own unique inflation rate. For example, individuals living in older houses that are poorly insulated are likely to be feeling the effects of higher energy costs more than those living in new-builds with modern insulation and renewable energy sources. Similarly, those that are frequent flyers (not that there are many people in this bracket at present!) have experienced hefty price hikes, whereas other transport services were far less impacted.

Table 2: UK price increase by transport type (2021)

Data source: ONS (2022)

Despite inflation being more nuanced than just the headline figure, it is true that a general rise in prices can be uncomfortable for investors, reducing the ‘real’ (after inflation) returns earned over a given period. That being said, the systematic investment philosophy adopted in your portfolio was built to weather such storms. Equity markets offer the opportunity to participate in the future earnings of global corporations, whose prospects rely on the goods and services they provide. Exposure to smaller and value companies – those that appear cheap relative to a fundamental measure such as book-value – offer the opportunity of diversification and higher expected returns.

Whilst no perfect inflation hedge exists – gold and commodities, for example, are no silver bullet – it is sensible to expect a well-diversified, low-cost portfolio consisting of equities and high-quality bonds to deliver above inflation returns over the medium to long term (in other words 10-years or more).

If you have any questions, thoughts or actions relating to the content of this article please get in touch with us by calling us on 028 9099 6948 or by emailing info@pacem-advisory.com

Risk warnings

This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy, or investment product.  Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

[1] CPI is a widely accepted inflation measure in most developed economies.

[2] ONS (2022) UK CPI. March 1992 – 7.1%, December 2021 – 5.4%.

[3] For example: 72 ÷ 5.4 ≈ 13-years to half purchasing power (i.e., £1 of goods now costs £2 in the future).

[4] Marketplace (2019) Why is inflation necessary? https://www.marketplace.org/

[5] Bank of England (2022) Inflation and the 2% target. https://www.bankofengland.co.uk/

[6] ONS (2020) Consumer price inflation basket of goods and services: 2020

[7] Rational Reminder (2021) Episode 178: Are inflation concerns inflated?

It feels at the moment that the markets have gone a little mad.  Almost everything you hear on the news or read about investing suggests that everything is going up.  The US market is up by around 44% in the past year[1] in dollar terms, Tesla’s share price has risen by 124% over the same period, and Lucid Motors, who have just started production on its electric car in Q3, for which it has (a mere) 13,000 orders, floated on the NYSE and already has a market capitalisation greater than that of Ford, after its share price doubled in a month!

In the US, call options on individual company shares, which provide investors the right to buy a stock at given date in the future at a predetermined price in return for a premium payment, currently exceed the value of actual shares traded by value by almost a half.  Options are a way of leveraging exposure to a stock without having to come up with the face value of buying the stock directly.  They are a sure sign of speculation, not least by retail investors.

There is no doubt that when markets become frothy, investors are prone to a fear of missing out (FOMO) that makes them wish that they were invested in something that has done well (mostly identified with hindsight) and tempting some to lose discipline and plunge in, hoping that the magic (luck) will continue.  When things do not go as hoped, there is a temptation to cut losses and run.

Let’s take a quick look at the ARK Innovation ETF that has hit the investment news headlines as one of the best performing funds in 2020, gaining over 150% in US$ terms, and more importantly how investors in the fund have fared.  It is a very concentrated portfolio of technology and healthcare innovators.  It holds more than 10% in Tesla and the top 10 of 45 or so stocks make up more than 50% of the portfolio. The firm also owns more than 10% of the shares of a number of portfolio stocks, which raises liquidity risks (remember Woodford?).

In the case of ARK Innovation, it had a stellar run from April 2020, out of the bottom of the Covid-induced sell-off until December 2020 but has struggled since then, falling almost 35% at one point in the first few months of 2021.

Figure 1: Fund flows often follow performance

It is worth noting that the fund had inflows of just US$25 million in Q4 2019 but these peaked at almost US$ 7.8 billion in Q4 2020.  You do not have to be a mathematician to work out that the investor money that went into the fund at the back end of 2020 will have not captured the bulk of the positive returns of 2020 and suffered the subsequent downswing. A rough calculation using monthly performance and fund flow data suggests that from the start October 2019 to the end of October 2021 the fund delivered an annualized return of 66% p.a., whereas the average investor return was around 25% p.a. i.e. a 40% p.a. difference.[1] Over this same period a well-known US index fund delivered 26% p.a.!¹

ARK Innovation relies on manager skill (or luck) in picking a mere 45 or so companies out of the many thousands of companies around the world.  The risks are very high. The fund management world is littered with the corpses of such ‘stellar’ funds.  In the UK for example, over the past twenty years or so, around half of all investment trusts launched have failed to survive[2] in their original form.

It is hard not to suffer FOMO at times like these, but it is worth remembering that investing is a not a sprint but a marathon.  When markets rise substantially, as they have done recently, regular rebalancing results in the sale of assets that have performed well and banks the excess proceeds.  Seemingly irrational markets can persist for a long time and as the old saying goes, no-one rings the bell at the top of the market.  Stay invested, remain diversified and be thankful that your financial well-being does not lie in the hands of any one fund manager owning just 45 stocks.  Remember that it is the tortoise who wins the race.

Risk warnings
This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy, or investment product.  Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

[1]     Albion Strategic Consulting used an XIRR calculation with monthly fund size, flows and performance data and assuming fund flow occurred at the start of the month.  It provides a rough estimate and order of magnitude insight.  Daily data unavailable.

[2]     Numis, as quoted in: Investors Chronicle. Surviving the investment trust shake-up August 6, 2020, By Dave Baxter

[1]      Vanguard Total Stock Market Index Fund in US$ Admiral share class www.vanguard.com