Interactive Investor

Bond Watch: US debt downgrade and the bond Bill Ackman is shorting

4th August 2023 09:00

by Sam Benstead from interactive investor

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Sam Benstead breaks down the latest news affecting bond investors.

Bonds screen 600

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.

Here’s what you need to know this week.

US credit rating downgrade

Bond rating agency Fitch Ratings has downgraded the credit rating of the US government from AAA to AA+ due to a “steady deterioration” in standards of governance over the past 20 years. AAA is the best rating, reflecting the lowest expectation of default risk.

It said: “The rating downgrade of the United States reflects the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to 'AA' and 'AAA' rated peers over the last two decades that has manifested in repeated debt limit stand-offs and last-minute resolutions.”

Credit ratings help investors determine how safe an issuer’s bonds are. Generally, the better the rating, the lower the yield they are willing to accept.

But Harry Richards, fixed income fund manager at Jupiter Asset Management, says that there is nothing new in the reasons presented by Fitch, and all reasons cited are known already by investors.

He adds that the S&P (another rating agency) downgrade of 2011, on the back of a debt ceiling stand-off, probably serves as a playbook for what happens next.

“In that situation, the downgrade did not generate any material sell-off in Treasuries, while risk assets saw some volatility,” Richards said.

Bill Ackman’s next big short?

Billionaire fund manager Bill Ackman has revealed that he is betting against long-dated US bonds on the grounds that they are not pricing in enough long-term inflation.

He thinks that due to de-globalisation, higher defence costs and the energy transition, among other factors, persistent 3% inflation globally is the most likely long-term scenario.

However, with the US 30-year treasury bond yielding 4.25%, he does not think this scenario is reflected in bond prices.

“So if long-term inflation is 3% instead of 2% and history holds, then we could see the 30-year Treasury yield = 3% + 0.5% (the real rate) + 2% (term premium) or 5.5%, and it can happen soon,” he said.

Because bond prices and yields move inversely, for the 30-year bond to reach a 5.5% yield the price of the bond would have to fall substantially.

Ackman is implementing the hedge by purchasing options that will rise in value if the bond falls, rather than shorting bonds outright – a process that requires borrowing bonds and immediately selling them with the hope of buying them back at a lower price in the future.

Bank of England raises rates

The 14th consecutive rate increase from the Bank of England saw rates hit 5.25% this week. The Monetary Policy Committee voted six to three in favour of the rate rise.

The Bank of England said it expected inflation to return to its 2% target by early 2025.

The move was anticipated by markets due to better-than-expected inflation figures in July.

Gurpreet Gill, a strategist at Goldman Sachs Asset Management, expects the Bank of England to deliver a further 0.25% rate hike for a peak rate of 5.5%.

“This is below market-implied pricing and reflects our more cautious outlook for growth, given higher sensitivity to rising mortgage costs relative to other advanced economies,” she said.

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