Q&A with Andy Chorlton: fear and opportunity in bond markets

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Two weeks ago the UK government unveiled its so-called “mini-budget”, seeking to increase the UK’s deficit but offering little detail to support its plan.

This emerged while the Bank of England, the Federal Reserve (Fed) and European Central Bank (ECB) are all at various stages of raising rates and tightening policy. Also while febrile markets are anxious to gauge whether inflation is showing signs of ebbing away – or becoming more entrenched.

To understand exactly what followed in the bond markets, and where that now leaves investors in terms of risk and opportunities, we spoke to Andy Chorlton, Schroders’ Head of Fixed Income.

So what's the last week been like for you as an investor in bond markets?

Andy Chorlton: “The best word to describe it is ‘bruising’. We’ve lived through volatility before, but it felt this was self-inflicted by a major government, and I think the one thing that surprised people was some of the ripple effects into other markets as a result of the challenges that the UK faced.”

How did it unfold?

Andy Chorlton: “I've never seen anything like it in a government bond market, certainly in a developed market. I guess it all started with the ‘mini-budget’ (as it's being referred to in the press here). The UK government announced a number of packages mainly to support the energy crisis, capping energy prices for consumers, and a number of tax cuts as well, which led to an increase in the deficit. Perhaps what the government misjudged is that just like in a corporate bond market, or any other asset class, you need to incentivise investors to buy your securities.

“There was a concern amongst bond investors that this unfunded tax cut and energy intervention meant that the price that the bond market would demand to lend money to the UK government, which is essentially what a bond is, needed to be higher. I think the magnitude of that increase – given that the government hadn't produced any further forecasts to support their plan – was much sharper than people expected.”

A lot of people, up until last week, had never heard of liability-driven investing (or LDI). Can you explain what it is and what it does, and why it had such an effect in the market in recent days?

Andy Chorlton: “If you think of a defined benefit pension plan – the kind of pension plan that was once common but which we don't really have anymore – it’s a series of cash flows that you owe to your retirees or those who are still in the plan. The way that a company manages that liability is to try and match the investments in the pension plan with those cash flows.”

“However, many of those pension plans were underfunded  and therefore had insufficient assets to meet their liabilities. The biggest influence on a pension fund’s assets is the movement in interest rates and inflation. LDI was developed to manage exposure to this risk and reduce funding volatility using a range of assets such as government bonds and other synthetic instruments, to match the liabilities. The balance of assets were invested to generate a return sufficient to close the funding gap.  This approach has been very successful securing the benefits of millions of pensioners.”

“Pension plans were slowly building up their funding ratio to make sure they had the money in place to pay those future pension plans. The challenge over the last week has been the extent and speed in which gilt yields at the long end of the market have moved.  We have not seen the type of moves in government bonds, typically seen as the safest place to invest aside from cash, of this magnitude. It was the extent of the move that surprised LDI managers and led to the need for additional collateral at very short notice.

“While the dust has yet to fully settle, what we expect to see is many pension plans being in a much better place now from a funding perspective than they were a few weeks ago. Looking forward there will be more focus on the levels of leverage in the system, the amount of available liquidity , and a lower-risk framework for liability-driven plans.

“It’s not that there were outsized positions on risky markets, these were investments designed to manage risk.”

The Bank of England stepped in on Wednesday 28 September, buying UK government bonds in response to what it called “a material risk to UK financial stability”. Can you explain what impacts the Bank’s actions have had?

Andy Chorlton: “We had the mini-budget and markets started moving on Friday [23 September] and then accelerated on Monday and Tuesday. I think there must have been a moment where the Bank paused, because the Bank is also trying to begin quantitative ‘tightening’. It feels slightly counterintuitive to have such a targeted quantitative ‘easing’ operation happening at the same time. What the Bank demonstrated was that it had a loaded gun in its pocket and the money was there if it needed to be spent.

“Once the market knows the Bank is willing to intervene, that loaded gun in the holster is enough for things to calm down and that feeding frenzy to abate.”

Given that it has not yet raised interest rates, what can you tell about the Bank of England's attitude towards inflation?

Andy Chorlton: “The market is expecting the Bank to continue to hike rates. I think the intervention last week was sufficient, and having an emergency rate hike perhaps would have given the wrong signal. I don't think it's changed the determination to beat inflation. The Bank reacted to a very clear and present danger affecting a particular part of the market for a very particular reason. And as I say, going forward, I think the risk will be much more muted.”

Has there been reputational damage for either the Bank of England or the government?

Andy Chorlton: “I think what the government missed in all this is that you have to persuade people to lend you money. That's what a bond is. The yield of a Portuguese bond is higher than that of a German bond; investors are telling you that they want a slightly higher compensation around Portuguese debt than the German debt, because the credit quality of Portugal is not as strong as that of Germany.

“Perhaps the UK government forgot that part, that they need to incentivise people to buy their debt. It's not like the US Treasury market, which is the go-to bond market in the world when people want to park money, when people want a “risk-off” asset. The UK doesn't have that benefit. Maybe the government misjudged that.

“Could the Bank of England have acted earlier? Yes, but it acted precisely. And did it have the right outcome? Again, yes.

“It's been a rocky few days, there's no question. I think it's important for the government to continue to be a bit more open because that's what will bring confidence back to international investors and their willingness to fund the UK deficit."

While the British pound and UK bond markets have stabilised for now, the moves last week happened at the same time as stock markets around the world fell again and the dollar strengthened further. Do you think the broader market volatility was a coincidence, or were events in the UK a trigger?

Andy Chorlton: “I do think there's been some contagion from the situation in the UK, mainly because pension plans look to assets overseas in order to create some liquidity. More broadly, what the market is contending with is this fight between the idea that inflation is entrenched and here to stay, versus an emerging slowdown [in inflation]. Investors are looking for signals that inflation isn't entrenched. They'll jump on any indicators [to that effect] and then when they are disappointed, you'll see sharp reversals. It is a volatile market because we're in that kind of zone where the inflection point is close – but we don't know how close.”

How investible is the UK at the moment given the standoff between the government policy, the central bank, and everything else that the economy has to contend with?

Andy Chorlton: “The good thing about all the challenges facing the UK is they're very well publicised. Hopefully there's nothing that we don't know about. Of course, investors like certainty and they'd like to see the clouds clear, but I think now is the time – from a bond market perspective – that people should start reassessing their allocation to fixed income and potentially increasing it. Look at where bond yields have moved just in the last, or just year-to-date. We can see short-dated credit at 7%. That gives a decent cushion for further uncertainty. So yes, there are still things that need addressing, but at the same time, valuations have corrected a long way.”

How long do you think dollar strength is going to remain a major theme for?

Andy Chorlton: “It does feel at the moment that the dollar always wins. We need stability in the dollar to open up, particularly in emerging markets, for both equity and fixed income. I think both would benefit from a stable dollar – rather than a dollar that feels like it's forever grinding higher. The interest rate differentials between countries are shrinking, so that should be supportive of the euro and sterling, but dollar strength is a trend that's been gone on for a long time and it would be a brave person who called the end of it.”

Internationally, what markets are looking attractive?

Andy Chorlton: “If you had my colleagues from Europe or the US here, they'd tell you to buy their markets. The US, obviously, it's the deepest, most liquid market. There is the biggest opportunity set there and the one thing you see in episodes like this is increased dispersion between credits. Certainly, from a credit perspective, my colleagues in the US definitely like the US credit market – particularly investment grade. I think they want to see a bit more earnings revision before moving into high yield.

"In Europe, arguably the ECB is behind the Bank of England and the Fed in terms of rate hikes, but again, that's well publicised. The credit markets there are already pricing in a mild recession. I guess the argument is the probability of mild recession versus something more severe, coupled with how much you are compensated in terms of yield for that uncertainty. Again, we're finding interesting opportunities across credit because of that dispersion.

“It's not that you want to blindly go in and buy the index: but you do want to go in, I think, and start looking at your exposure and potentially increasing it to credit both in the US and Europe.”