Investors Should Expect Bond Yields to Rise in 2017

ASK THE EXPERT: Morningstar Investment Management's Mark Preskett says gilt yields may fall in 2017 but bonds still have an important role to play in investor portfolios

Emma Wall 3 January, 2017 | 2:37PM
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Emma Wall: Hello and welcome to the Morningstar series, "Ask the Expert." I'm Emma Wall and I'm joined today by Morningstar Investment Management's Mark Preskett.

Hi, Mark.

Mark Preskett: Hi.

Wall: So, it's a bit of a case of déjà vu January 2017, because if we look at what the market is expecting in terms of interest rate rises, it's 2% to 3%, but we were expecting 2% to 3% rate rises this time last year and it didn't exactly come to pass, did it?

Preskett: Yeah, absolutely. So, if we look at the 10-year gilt yield, which is sort of the benchmark government bond yield that most investors look at, we're trading at around 1.35% yield. At the beginning of last year, 10-year government bond yield was at 2% and people expected, investors expected a couple of rate rises and bond yields to gradually rise up to their fair value levels.

That didn't come to pass as we know. Uncertainties around the Brexit vote happened and we actually got gilt yields traded down to 60 basis points, 0.6%, which was a record low. So, while that's not our base case scenario for this year, it's still something that investors should be mindful of.

Wall: Well, of course, gilt yields remain low and we are expecting for gilt yields to rise slightly this year. This means that prices will fall and investors will lose money. However, there is still a case to be made to include gilts in a portfolio, isn't there?

Preskett: Absolutely. I mean, even if gilt yields rise, that is a mid to low-single-digit loss for holders of the asset class, but they are an excellent hedge against future market nervousness, volatility and they've proven throughout 2016 to be the ultimate hedge against equity risk. Cash is still your friend in terms of its 0% correlation to equities, but government bond yields, especially the long bond, has shown negative correlation to equity market risk.

Wall: And of course, when it did drop to that record low yield of 0.6%, you did get an uplift in price?

Preskett: Absolutely. So, the asset class itself returned 10.5% for investors throughout 2016 and this is with a very weak Q4 when yields rose and prices fell. So, there's definitely a case to be made for holding the asset class.

Wall: Looking then more broadly at the bonds asset class, at fixed income, what should investors expect from U.K. corporate bonds in 2017?

Preskett: So, the corporate bond market is trading around fair value in our view in terms of spread levels. So, spread is the difference in yield between an equivalent corporate bond relative to an equivalent government bond of the same maturity. And we see around fair value, so that does give us some protection against rising yield environment. But ultimately, the path of government bonds will impact corporate bonds and if we see a rise in yields on the government bonds side, we will see some losses on the corporate bonds side as well.

Wall: So, I suppose, what you're saying is, bonds are a great diversifier, but perhaps the equities look a bit more attractive?

Preskett: From a fair value perspective, yes, I think, that's true. But as I said, we still think that for a cautious investor or more defensively-minded investor government bonds and sort of high-grade corporate bonds have a place in a portfolio.

Wall: Mark, thank you very much.

Preskett: Thank you.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

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Emma Wall  is former Senior International Editor for Morningstar

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