2017 has started well for fixed income despite a very strong uptick in consumer price inflation. Pre 2008 rising inflation would have hurt bond investments.
Since 2008, distortions created by the zero interest rate policy (ZIRP) and quantitative easing programs introduced by many countries have meant short term inflation expectations are no longer the chief determinant of fixed income prices.
UK Consumer price inflation (March 2017: 2.3%) is rising due to strong consumer activity, higher import prices (caused by the weak pound) and inflationary pay settlements. This trend should continue over 2017.
Current inflation (2.3%) exceeds the yield to redemption all along the yield curve.
|Gilt- edged stock||Price||Yield to Redemption||Real Return (- CPI)||COMMENT|
|Treasury 0.5% 2022||99.98||0.504%||-1.79%||5 year gilt has highest negative return|
|Treasury 4.25% 2027||131.60||1.085%||-1.21%||10 year yield suggests rates just over 1% for 10 years|
|Treasury 4.25% 2032||137.48||1.472%||-0.83%||15 year gilt yield also negative|
|Treasury 4.25% 2046||157.73||1.744%||-0.55%||30 year gilt yield also negative|
One factor is intense competition in the £1.3trn UK mortgage market. A recent fixed rate offer from the Yorkshire Bank (2 year fix at 0.99%) undercut HSBC. Normal 2 year and 5 year fixed rates are in the 1.25% – 2.5% range. The 2 year mortgage pricing suggests lenders do not expect Base rates hikes until 2019.
Whilst daily fixed income price movements are muted, quarterly trend movements can be substantial. In the aftermath of the June 23rd 2016 EU Referendum there was a discernable up trend, which reversed in the run-up to the US Presidential election. Since February 2017, 10 year gilt prices have moved up cutting the yield to 1.02%
10 year gilt price has jumped c. 4 points from January 2017 lows
Is a 1% nominal yield enough return to compensate UK pension funds and other institutions for holding to maturity?
Our conclusion is a) Fixed income prices are elevated due to ZIRP b) Investors are expecting ZIRP to remain in place to 2022 – this is arguably unrealistic c) Gilts low absolute and “real” returns.
Back in September 2001, Barclays, the UK High Street lender issued £350m 5.75% subordinated notes due in 2026. These bonds will mature on 14th September 2026 at which point, Barclays is obliged to repay £100 per £100 nominal of these bonds.
These bonds are dated tier 2 bonds and subordinated i.e. they rank low down in the capital structure, above equity and preference shares but below senior debt and debentures.
There are three note denominations, £1,000; £10,000 and £100,000.
The Barclays 5.75% 2026 bond is listed on the retail order book of the LSE with reasonable liquidity of around £100k per day.
Last September Barclays launched an offer to buy back a portion of this bond at a small premium – it repurchased c. £144.6m of this issue reducing the o/s principal by 24%. Barclays could undertake a similar buyback program in 2018.
The 3% yield to redemption is attractive compared to similar corporate bond issues in the 9-10 year range.
|52 Week Hi/Low||£122.90/ £79.60|
|5 Year Hi/ Low||£125/ £80|
|Avg. Daily Volume||c. £100k|
|Yield to Redemption||3%|
Recent price movement has broadly mirrored the underlying 2026 gilt notwithstanding the jump in price during the tender offer.
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