- Since the beginning of the year, rising inflation has caused a noticeable rise in interest rates on the bond market.
- This has increased speculation about an end to central banks' expansionary monetary policy.
- However, an abrupt end to monetary policy support seems unlikely. More likely, it will be reduced gradually.
"Buy bonds, don't take sleeping pills and keep an eye on the papers." This is how a well-known piece of advice from twentieth century stock market guru, André Kostolany, could be rephrased to describe the current investment situation in fixed-income investments.
Just buying and holding is not enough for many bonds at the moment – especially safe government bonds.
In the original quote, Kostolany said that to achieve a good return on equities, one should buy securities, sit on his hands and hold them for a long time, even through turbulent phases of the stock market. But is the advice transferable to bonds? "In a low interest rate environment, the recommendation should not be applied to many bond segments," says Oliver Eichmann, Fund Manager at DWS Eurozone Bonds Flexible. Here, buying and holding until maturity has often been a losing proposition – especially with government bonds from industrialised nations such as the US and Germany, which are considered safe. The strategy was only successful when applied to securities with a higher default risk – for example, government securities issued by emerging markets or high-yield corporate bonds.
Now, in recent weeks, increasing market yields as a result of rising inflation rates[1] have brought movement to the market. In the US, rates on bonds have risen noticeably again along with real consumer price inflation – and investors are wondering how long it will last.
Current central bank policy sets the pace on the bond market
All eyes are on the central banks since their monetary policy influences general interest rate development. In recent years, monetary policy measures have focused on providing liquidity to the corporate sector through low interest rates and bond purchases – and this has been even more intensive since the outbreak of the COVID-19 pandemic. Low policy rates allow bond issuers to raise capital on favourable terms, while increased bond-buying programmes by central banks raise demand in the market, supporting bond prices. "Rising bond prices mean falling future yields," explains Eichmann. Therefore, he adds, "A buy-and-hold strategy is currently comparatively unattractive for investors in many securities with low default risk."
Central banks must weigh up when to curb inflation.
Inflation rising on both sides of the Atlantic recently coupled with the economy being on the road to recovery has fuelled speculation about an end to expansionary monetary policy in the near future. In the current economic situation, central banks have to weigh up more carefully whether and when to change the lever from "stimulate the economy" to "slow down inflation".
The experts at DWS expect inflation rates to be relatively high in the coming months. However, since this is mainly seen as a consequence of the revived real economy after the deep pandemic crash, it is likely to be a temporary increase. Over two to three years, inflation should become more moderate again, as the economy is not yet running at capacity and consumer demand is subdued due to higher unemployment. "On balance, we therefore expect that the central banks will only gradually and very cautiously reduce their monetary policy support and thus dampen the current rise in interest rates," says Eichmann.
Active management can achieve a positive real return on bonds
For investors, the bond market is therefore likely to remain a challenge. One can see this especially from the fact that in the US, fixed-interest yields have lately not been rising at the same rate as inflation. Investors who want to achieve a dramatic return with interest-bearing investments even after deducting inflation would therefore have to invest in riskier and thus higher-yielding bonds such as corporate bonds.
For those who want to keep investing in bonds but still want to sleep soundly, actively managed funds could be a good choice compared to an individual investment – for example, one with a high default risk. Risk diversification is one advantage of bond funds. "As a fund manager, I can react quickly to new market events and continuously adjust bond maturities," says DWS expert Eichmann. Active security selection offers him the opportunity to take advantage of price opportunities and achieve higher returns overall.
The central banks are likely to reduce their expansionary monetary policy only very slowly despite the rise in inflation.
