‘Too early’ to add bond duration in UK, says AXA Investment Managers’ Trindade

It is ‘too early’ for UK fixed income investors to rotate into long duration bonds, with stubbornly high inflation, rising interest rates and an inverted yield curve rendering the trade unattractive, according to AXA Investment Managers’ Nicolas Trindade. 

The Bank of England (BoE) recently hiked interest rates by 50 basis points to 5% in a further attempt to tackle persistently high inflation, which rose in May to 7.1% from 6.8% on the core CPI measure. While there was a sense of relief that CPI and core CPI fell in June to 7.9% and 6.9% respectively, the latter remains some way above where it had been expected to be just a few months ago and is significantly above US and Euro levels.

The yield on 2-year UK gilts now stands slightly below 5.0%, a level not seen since the 2008 Global Financial Crisis, while 10-year gilts trade substantially lower at around 4.2%. With the UK yield curve so inverted – and the BoE likely to hike rates again – Trindade, who manages short duration strategies at AXA IM, says investors are unlikely to benefit from being early to the ‘longer duration’ bond trade.

“With inflation data surprising on the upside this year, we've seen quite a big market repricing for peak BoE interest rates,” he says. “The consensus is now slightly below 6% and while we don’t expect the rate to reach that level, clearly the yield curve is going to remain inverted. If you’re getting more yield from short-dated bonds than long-dated bonds with less sensitivity to interest rate rises, why lengthen duration? It is too early to make that trade.”

Trindade says he is currently able to acquire AAA-rated two-year bonds yielding 6%, meaning prices would have to fall precipitously over one year for investors to post a negative total return, with virtually no credit risk.

“If we continue getting upside inflation surprises, the BoE is going to have to keep raising interest rates and I want to be at the short end of the market in those circumstances,” he says. “The great thing about short-dated bonds today is that breakevens are high because yields are so high. That means investors not only have significant protection against future rate rises, but also a high return even if yields don’t come down as coupons are so attractive.”

When inflation does fall meaningfully, Trindade cautions that economic conditions are likely to have worsened, which could prompt a change of direction from the BoE that will not necessarily reward investors moving quickly to lengthen bond duration. 

“It will take some time before the full impact of interest rate rises flows through to the real economy, but I think the data between now and the winter will start showing a deterioration in economic activity and more slack in the labour market,” he says. “Once that comes through, the market will start thinking about interest rate cuts and then we will see a ‘bull steepening’ of the yield curve, when front-end yields will fall by more than those at the long end. 

“We understand that investors don’t want to miss the boat with the longer duration trade, but we believe that short-dated bonds remain the best place to be in fixed income for now.”