Bond Watch: bonds rally and yields fall, as inflation cools more than expected

Sam Benstead breaks down the latest news affecting bond investors.

Welcome to interactive investor’s ‘Bond Watch’ series, covering the latest market and economic news – as well as analysis – that is relevant to bond investors.

Our goal is to make the notoriously complicated world of bond investing simpler, by analysing the week’s most important news and distilling it into a short, useful and accessible article for DIY investors.

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Here’s what you need to know this week.

Finally, a good inflation surprise

The Bank of England would have breathed a deep sigh of relief on Wednesday, as UK inflation fell more than expected.

Prices rose 7.9% in the 12 months to June, below the 8.2% expected. Core inflation, which excludes volatile food and energy prices, fell to 6.9%, from 7.1% in May.

In response, bond prices rose significantly, therefore leading to lower yields. Investors were betting that the central bank would not have to raise interest rates as much as previously thought on the back of the inflation figure.

The two-year gilt yield, which is a key measure of where investors think rates will be in the short term and is key to pricing mortgages, fell from 5.2% to 4.8% on the news.

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Jim Reid, a strategist at Deutsche Bank, said that the reading showed that peak core inflation could be behind us, and downward momentum was gathering pace.

He said: “As energy prices fall, and food inflation normalises, the likelihood of downward effects into the ‘core’ CPI basket will only rise. 

“Where to now? We still think it will be some time before CPI settles at the Bank’s 2% mandate (early 2025). But there is good news for government: amid sticky services inflation, headline CPI is now on course to drop below 5% year-over-year.”

With the Bank’s next decision due on 2 August, the debate is now around whether they will raise by 0.25 or 0.5 percentage points.

Reid reckons that, at the moment, the odds are 50/50, but before the inflation number a 0.5 percentage point increase was more likely.

Are emerging market bonds too risky?

Fixed income tends to attract cautious investors, and so emerging market bonds are off limits for many.

This makes sense, as currencies, fragile economies and ever-changing politics can have big effects on bond valuations.

However, Thomas Fishchli Rutz, head of emerging market debt at Swiss fund manager Fisch Asset Management, thinks that money should begin to flow into emerging market bonds.

He said: “The public at large – and therefore investors too – tend to see emerging markets as being a bit of a roller-coaster ride. This perception is incorrect, however.

“Cautious optimism is the prevailing mood among investors at the moment – notwithstanding the somewhat uninspiring news emanating from the biggest emerging market of all: China. We therefore expect to see a resumption of inflows into the emerging market corporates asset class in the second half of 2023.”

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Fishchli Rutz says that on a risk-adjusted basis, valuations of emerging market corporate bonds are just as attractive as those of emerging market government bonds, as well as government and corporate bonds in the industrialised countries.

Inflation-adjusted returns for emerging market bonds were 9.5% for high-yield bonds and 7.25% for a broader index, over the past few years.

Fishchli Rutz says: “Corporate fundamentals remain solid. In addition, the impact of the two biggest negatives of the past year – the significant tightening of interest rates and the war in Ukraine – is steadily waning. What’s more, in contrast to the European Central Bank and the Federal Reserve, emerging market central banks began combating inflation at an early stage and now have sufficient headroom to ease monetary policy and stimulate their economies.”