Bond Watch: what fixed-income investors are watching ahead of the Budget

Wednesday’s CPI print of 3.6% for the year to October evidences easing inflation.

Taking that in tandem with weaker recent employment data, the way looks clearer for another rate cut from the Bank of England before 2026.

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Yet counterintuitively, those closely watching gilts will have noticed that, particularly at the long end, yields sit materially higher than a week earlier.

Long-dated gilts have been under pressure given concerns regarding the UK’s fiscal outlook, and the Autumn Budget on 26 November is a critical juncture for UK fixed-income investors.

Yields resurged late last week following Chancellor Rachel Reeves’ announcement that Labour will no longer consider raising income tax, which would have meant backtracking on a manifesto pledge.

Investors want to see credible fiscal policy from Reeves and commitment to reducing borrowing to rectify an estimated £20-40 billion fiscal black hole.

While individuals may have dreaded a hike to income tax, the gilt market reaction shows investors are now more pessimistic of Reeves’ chance of success off the back of the renewed affirmation that the government will not raise taxes (at least directly) on “working people”.

Increasing tax revenues

Instead, the freezing of tax thresholds, higher taxation of dividends, a gambling tax raid and increasing bank surcharges are workarounds the chancellor may deploy to avoid reneging on the pledge.

While these should boost tax revenues, the knock-on effects for what is already an unimpressive economic growth rate are concerning.

• Bank of England chooses caution ahead of Autumn Budget
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Further, there may be direct implications for sterling corporate bonds if tax policy puts pressure on domestically focused companies’ balance sheets, although we might hope that investment in other areas will bolster some corporate sectors.

Additionally, per economist Arthur Laffer’s eponymous Laffer curve, the danger also exists that excessive tax increases counterintuitively result in reduced tax revenues and a worsened fiscal position, as consumption and investment is discouraged.

Reduced spending

Naturally, the other side of rectifying a deficit is cutting expenditure.

The market would likely welcome this frugality as spending cuts – so long as they do not impact growth - are typically viewed more positively by the market for sustainably improving public finances.

However, the extent to which this will be possible is questionable given that cuts to expenditure are a tougher political matter, as was evidenced by the party’s inability to make relatively smaller spending cuts (worth around £5 billion by 2030) already this year.

What’s the near-term outlook?

While that paints a rather gloomy picture, there are reasons to be confident that we will avoid a full-scale bond market crisis (akin to 2022’s) in the near term.

Whatever the pain upcoming for the British corporate and individual taxpayer, Reeves has shown some willingness to comply with the wants of lenders and widen the country’s fiscal headroom from the slim £9.9 billion previously achieved.

High-quality government and corporate bonds represent a still attractive source of yield for investors, but short-term uncertainty is a certainty until Labour’s plans are laid out next Wednesday.

For those looking to tap into the high yields across the UK government and corporate bond market, a now defensively positioned option is the Invesco Sterling Bond fund from ii’s Super 60.

The fund is managed by Michael Matthews and Tom Hemmant and flexibly manages duration and credit quality, which have varied greatly through the fund’s lifetime.

Given the narrowness of spreads across sterling bonds, the fund is now almost entirely (95%) allocated to high-quality, investment grade issuances, with nearly half the fund in A-rated or higher.

While focused on corporate bonds, the fund also allocates to both conventional and index-linked gilts.

With a modified duration of around six years the fund is fairly exposed to interest rate changes, but the managers have a good record of adjusting the portfolio to outperform including in difficult periods such as the bond market rout of 2022.