Why bonds can protect you again

Sam Benstead interviews Invesco Sterling Bond manager Michael Matthews about the role of fixed-income (bonds) in portfolios.

Matthews speaks about how his fund is positioned, including his allocation to gilts and how much interest rate risk he is taking.  

The fund manager also gives his predictions for inflation and interest rates in the UK this year.  

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Sam Benstead, fixed income lead, interactive investor: Hello and welcome to the latest Insider Interview. Our guest today is Michael Matthews, manager of the Invesco Sterling Bond fund. Michael, thanks very much for coming into the studio.

Michael Matthews, manager of the Invesco Sterling Bond fund: Morning.

Sam Benstead: The past five years have been very difficult for bond investors. Your fund is up 6%, ahead of peers, but only up 6% over this period of high inflation. So, what's gone wrong for bonds over this difficult period?

Michael Matthews: I guess the last five years isn't the most flattering period for fixed-income returns. When I look back from my career, the best part of the first 30 years, it was very bond friendly, we had risk-off periods, but it was a very bond-friendly environment.

But the last five years, if you think back to the starting point, I guess it was just post-Covid, you think back to what the bond environment was like then, you had zero interest rates, you had negative yield in places, you had governments doing quantitative easing (QE), corporate investment-grade bond yields, probably were yields of 1.3%, 1.5% and at all-time lows, and then in the last five years, it's a completely different environment.

As you said, inflation has been a lot higher. Central banks have had to tighten policy a lot further than anyone thought five years ago. We now have quantitative tightening (QT) rather than QE. We had the Liz Truss mini-budget, we had the LDI [liability-driven investment] sell-off and we're in this completely different rate environment. In 2022, I think, the gilt index was down 25%. So, as soon as you're including that year in any five-year period, it makes it a pretty unattractive backdrop or outcome.

But looking forward, I think it's a much better place to be. It was a bit frustrating as a bond fund manager when we had yields of 1%, 2%. It's like, how can an active fund manager really add much in the way of added value? Everyone just focused on the fee versus the yield because it was a big component.

But now we've got yields a lot higher. When you've got the gilt yields at 4% to 5.25%, you add on a credit spread. You add a bit of duration as well, and you're getting some pretty good-quality companies that are paying you yields of 5.5% to 6.5%. I think it's a much better backdrop looking forward. But looking back, the last five years have been challenging for fixed income returns.

Sam Benstead: So, is today a better time to be investing in fixed income?

Michael Matthews: It's interesting because central banks have been cutting rates, albeit small and gradually, but whether you're looking in the US, Europe or in the UK, central banks are cutting rates, which would normally be a favourable backdrop for bond returns.

But there's two other components. One is there's a lot of issuance that governments are doing, so people are worried about the supply.

Inflation has probably been stickier than people thought and [they] are worried that central banks probably can't do that much more in terms of loosening policy. But the other thing is credit spreads are quite tight. So, while we talk about bond returns and them having not been that good over the last five years, actually, in terms of credit spreads, we're at close to a post-great financial crisis tights in most areas of the market. So, for us, looking forward, probably having some duration risk in the portfolio is maybe a slightly better risk/reward than necessarily going too far down the credit-risk spectrum.

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Sam Benstead: What's your view on interest rates in the UK? And by the end of this year, where could interest rates be?

Michael Matthews: I'm not sure we necessarily think interest rates are going to come down aggressively. In terms of central bank policy, I think the market is pricing in two cuts. Another one in May and one in August that will take us down to 4% in the UK. There are some commentators that think that probably it will be difficult for the Bank of England to cut again because wage inflation is sticky and with the Trump tariff threats, inflation could be picking up.

Our own desk economist, he's still bearish on the UK and thinks we could have 100 basis points of cuts. For us, we probably do have a bit more duration than peers, our duration in the portfolio is about 6.2, the index is about 6, so we're slightly long. But we are still very aware there is a lot of issuance to come. When you've got a trillion of gilts to fund over the next few years, you do worry about the supply, but what we do think is, as I mentioned, when you've got a yield of 5.25% at 30 year, if you add on a 150 credit spread, you can get to what, historically, you'd be thinking would be a yield that you'd be getting on a much riskier asset, whether it's been the AT1 market or high-yield market.

Rate volatility has been an issue. You have to live with that volatility. It's very difficult to be sitting here saying duration or interest-rate risk is very cheap. If equity risk, or the equity volatility that we've seen of late with the Trump tariffs, if that starts to be a bigger thing and equity starts to sell off more and people start to be worried about risk, maybe government bonds and interest-rate risk could give portfolios this nice diversification where you'll have, probably, them going up in price to offset the equity price fall.

So, we are a bit long duration versus peers, not massively so, but because unlike pre the last five years when yields were really so low, we now think they may not be getting cut, but at least they're giving you a nice income and a nice potential capital appreciation in a risk-off environment.

Sam Benstead: The higher yields you've spoken about need to be interpreted in the context of higher inflation in the UK, so currently at 3%. What's your view for inflation this year?

Michael Matthews: I think for this year, inflation could be tricky. You're hearing it all the time with central bank commentary, where you really get the sense that they want to be cutting rates. You can see that they're worried about, in the UK, with the national insurance changes, they're worried about the growth slowing. But at the same time, wage inflation has remained sticky, and now you've got the threat of tariffs pushing inflation up.

We're almost back to this period where central banks are starting to justify high levels of inflation as being transitory. We don't need to worry about them at the moment. We're so scarred by recent years, I think the markets are going to be focused on the inflation numbers.

So, maybe it will be hard for governments to rally that much this year, unless economies really start to slow a lot more. Our view probably isn't a risk of higher inflation this year, but I think you have to put it in perspective, it's not the double-digit inflations that we had that caused the bond sell-off before, and even with inflation in the high 2-3%, if you've got 5-6% yields, that's actually not such a bad outcome and a lot better than where we were.

Sam Benstead: You can also invest in gilts. What percentage of the fund is in gilts? And is this a typical allocation?

Michael Matthews: I think with an actively managed portfolio, especially where duration is so much of a focus, it can change. At the moment as we're sitting here, it's probably 6% to 7% in gilts. A lot of that is in long-dated gilts. But if the rate environment changes or there's a lot of supply, it's something that we will trade around.

Pre the 2000s, we had very little in gilts when the yields were as low as they were. We only really started adding duration to the portfolio, as always I think with active managers you're a bit early, but most of the duration that we added, we were building into it pre the LDI sell-off and then we took it up kind of during the LTI sell-off because the spreads widened and gave us the opportunity to add credit risk as well as adding the duration. So, at the moment, gilt position is about 6-7%, but it is a moving thing.

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Sam Benstead: The actions of Chancellor Rachel Reeves are very important for gilt pricing. What's your view on the progress she's trying to make at the moment in terms of cutting the Budget deficit?

Michael Matthews: How do I word this? If your argument or your basis of being overweight, being positive on duration, was on Rachel Reeves being able to reassure the markets was the reason, I probably wouldn't have the duration.

I think the reason for us to have duration in the portfolio is because we think the UK economy is struggling with the change of national insurance, and probably will continue to struggle. I think the government is in quite a difficult position with their fiscal rules.

And also the amount of supply, it's as we saw recently with Budget deficits going up, I think they're going to keep trying to do what they can to not break their rules, but I think it is a challenging backdrop for the government.

But it's the same for all governments, the UK is quite often in the spotlight for obvious reasons, but wherever you look, whether it's the US or in Germany, there's a lot of government issuance everywhere.

Sam Benstead: And you prefer the longer-dated gilts, so this duration element, their prices are going to rise more if interest rates fall, but why aren't you in the shorter end where you can lock in a fixed return, as we see a lot of our customers doing, buying bonds that would mature in two or three years' time?

Michael Matthews: Well, I think it's because it's a credit portfolio. So, where we were chatting earlier about the breakdown of a portfolio, and whether you have the credit risk or the interest rate risk. At the moment, what you've got is credit spreads that are quite tight and credit curves are very flat. So, when you're lending to a corporate, whether you're lending at five years or 30 years, the credit spread doesn't go up that much.

But the interest-rate curve, the front end, it's just a little over 4 in the long ends, a little over 5.25. So, the interest rate curve is a lot steeper and the credit curve's very flat. So what we've been doing is quite often having credit at the front end...why take a 20-year corporate risk when it doesn't pay you that much more in spread terms than if you lend to a company for five years, but then having duration. So, we use gilt futures as well. We have long gilts and gilt futures as a way of taking the overall portfolio duration up.

Sam Benstead: And finally, the question we ask all our guests, do you personally invest in your fund?

Michael Matthews: Well I hope all the responses you get are 'yes' because I think it is important that fund managers invest in their own funds and I always have done. In fact, probably at the moment, given my view on the relative attractiveness of sterling investment-grade versus other asset classes, I probably have more invested in the fund than I ever have done.

Sam Benstead: Michael, thanks very much for coming in.

Michael Matthews: Thank you.

Sam Benstead: And that's all we've got time for today. You can check out more Insider Interviews on our YouTube channel, where you can like, comment and subscribe. See you next time.