What will happen to inflation, interest rates, and bonds in 2024

Rathbone Ethical Bond manager Bryn Jones sits down with ii’s Sam Benstead to discuss fixed income investing in today’s market. 

He gives details of his portfolio, including why he likes the banking and insurance sectors, and goes into depth about the ESG overlay the fund implements. This includes why he can’t invest in gilts, but can invest in green gilts. 

Jones also gives his view on what will happen to inflation and economic growth this year, and how they will affect bond prices. 

Rathbone Ethical Bond I Acc is a member of ii’s ACE 40 list of recommended sustainable funds.

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Sam Benstead, deputy collectives editor, interactive investor: Hello and welcome to the latestInsider Interview. Our guest today is Bryn Jones, manager of the Rathbone Ethical Bond Fund. Bryn, thank you very much for coming in.

Bryn Jones, manager of the Rathbone Ethical Bond Fund: Hi. How are you doing?

Sam Benstead: Very well, thank you. So, bond investing is about reading the macroeconomic environment. Inflation and interest rates play a big part in determining bond prices. So, what is your outlook for these two key economic indicators?

Bryn Jones: Macroeconomic data last year started to kind of indicate that we were starting to see economies slow a bit. The thing with macroeconomic data is that it's very mixed at the moment. So, you've got very low unemployment. Historically that's been a good indicator of economies doing well, and yet you've got growth that's running at kind of a fairly low level. So, we've had some of the fastest and highest interest rate rises in history and you know there is this long variable lag, when rates go up they tend to slow economies. And it's interesting that if you look back through history, most interest rate rises do cause recessions, but they don't cause them for quite some time.

If we go back through history, from the first interest rate rise to the first recession, we'd have only had two by now. Most of them would be happening in the summer of 2024, into 2025. So, we have to be conscious of these long variable lags, you know, mortgage rates going up, borrowing costs going up, slowing economies, banks not lending as much because they're worried about defaults. And that does tend to slow an economy.

So, we are worried about kind of a general slowdown. But we're coming from a place where we've had a huge amount of money supply and excess savings. And in the UK we have still got excess savings. One of the interesting statistics over the last few years has been in aggregate. If you take all the money that's on deposit and look at the net interest that's been earned on that, and then look at all the increase in interest costs for mortgages, the money on deposit interest outweighs the increases in interest costs.

And while you might hear in The Daily Mail, and there has become this dichotomy in the economy of those with mortgage costs going up, actually those with savings in aggregate have increased their wealth. So, the economy might not slow as quickly as people would expect, and the hard landing might not be as hard as people expect. So, that's what we're looking at from the macroeconomic picture.

On the inflation side, inflation ramped up well above expectations in 2022. You know, double digit inflation, and it's remained sticky. We've still got some of the structural issues; Brexit was inflationary with employment and the inability for Europeans to work in the UK, which became a big problem. We've also seen some food supply issues. Now we've got geopolitical risk in the Middle East and the Red Sea. All these things can add to sort of structural changes in inflation.

And so while we do think inflation will fall, because of the impact of interest rate rises, perhaps inflation might not fall as fast as people expect. So, this is a strange environment where you've got macroeconomic data that we're expecting to slow, but it hasn't slowed as much. And inflation we're expecting to slow and it hasn't slowed so much. So, we might be in a situation where yields remain fairly high for some time.

The important thing is, in terms of what central banks try and do, is that, weak growth effectively affects some of us. High inflation affects all of us. And if you listen to [Jerome] Powell, he really wanted to smash inflation down. It doesn't matter if we might get a bit of weak growth because it only affects some of us. And I think that's what central banks will continue to focus on. They'll look at core inflation and try to bring down inflation over the next year. And it might be harder than they expect.

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Sam Benstead: And given this backdrop, what are you buying? What is in the portfolio and how much duration or interest rate sensitivity is there?

Bryn Jones: Well, with so many different moving paths at the moment, it's very difficult to take one view or the other. Historically, if we went back from 2021, we reduced our duration because we thought rates were going to go up. And that was a very easy thing to do. Just before Covid, we raised so much cash because we thought credit spreads were going to widen and we did very well because asset prices fell 50% and we were back in buying them with the huge amount of cash we got.

Right now, it's quite tricky. Are we going to have no landing? Are we going to have a soft landing? Are we going to have a hard landing? All the things I've just said - is inflation going to remain sticky? Are central banks going to be successful? So, the way we've constructed our portfolio is around benchmark neutral duration. And what we tended to do is say: "Right, well we don't know if we're going one way or the other", but we get technical moves. Nothing ever moves in a straight line, you get things like relative strength indicators and Fibonacci. And when prices have moved too aggressively, like they did in December and some of the periods of last year, and they hit our technical levels, we sell them. We sell duration and come shorter.

And similarly, like this week in January, we've seen a rise in bond yields and that's meant that this provided a good buying opportunity. Just this morning we were out buying some longer duration assets and we've been trading around the neutral part, but using relative strength indicators so that we're never too far away should it shift one way or the other. And the other thing with credit risk is that if we are entering this long variable lag where credits going to underperform at some point because of default risk or refinancing risk, you don't want too much duration in your credit portfolio.

And so what we've done is kept most of our credit sub 12 years. So, we are taking risk. We’ve got loads of yield and good companies. But should there be weakness, the spread widening is not going to impact the price too much. So, our portfolio is constructed with good BBBs, some subordinated debt, legacy bank debt and some other exciting opportunities down the front end to give us loads of yield.

And as you go further up the maturity structure, we've de-risked, we've got green gilts, European Investment Bank (EIB) and housing associations so that we're not impacted. So hopefully, and what we've been talking to clients about, is that in all scenarios we should be outperforming our peers. And that's what we've tried to put in place this year.

Sam Benstead: And financials is a big sector you invest in? I think it's about 80% of the portfolio, so why is that? And what types of bonds are you buying from that sector?

Bryn Jones: So, our big overweight is insurance. Our banks are pretty much aligned with the UK market, for example. The UK financial services is a big part of the UK economy. It's an ethical fund as well, so we can't invest in tobacco and alcohol and some of the manufacturers. So, our focus has been overweight financials, but the banks are pretty much neutral. But we've been buying subordinated banks. So, things in the tier two space, which are a little bit lower than the senior bank paper, and it's giving you a much higher yield.

But in the insurance space we've been buying, life insurers and the various universe of insurers, up to about 40% of the portfolio. What's interesting about banks and insurers is they're not what they were in 2008. You take 2008, core tier one capital in the UK banks around 5%, Spanish and Irish banks sub five, 3%. You're looking at CET1 ratios from the big UK banks in double digits somewhere between 10% and 15%. And then you take the building societies like Nationwide and Coventry Building Society in excess of 20%. Now this is capital. They've got so much solvency compared to what they had in 2008.

If you look at the Bank of England stress tests, they are really onerous and every single one of the UK banks is still a going concern with management action after some quite serious stress tests. So, as a bond investor where the capital is protected, we quite like the banks. And the same is true in the insurance sector. There's huge amounts of solvency. You take Rothesay Life, it has over 300% of excess solvency. I mean that's a huge amount. We're talking billions, over £5 billion of excess capital. And yet the bonds trade on a 12 or 13% yield, that for us is in an attractive universe. And that's why we're overexposed to that area, because we think they are more defensive than people think.

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Sam Benstead: And what sectors do you not invest in? I saw you sold some property bonds recently. Why was that?

Bryn Jones: So obviously we don't invest in those non-ethical companies like tobacco and gambling etc, we have a negative screen. Commercial real estate's been an area that we've sold back in 2021 as rates started going up. We were very conscious we didn't want to be in companies that would struggle at the back end of an interest rate rising cycle. What kind of companies would struggle in that scenario? If rates are very high, people find it difficult to borrow. They find it difficult to buy properties, in which case you don't want to be in the property sector. Commercial real estate in another sector in Europe, we felt was quite weak, so we've avoided those companies.

Also, businesses that are very cyclical. So, as we talked about the banks, we felt that there's good cash flow in all economic scenarios, albeit some non-performing loans do pick up in a weaker economy. So, businesses that are cyclical, or very simple singular cash flow that they can't diversify their earnings, and that's another area that we've avoided. So, we've tried to keep in good-quality businesses with good diversified cash flows and [those] that are not exposed to an interest rate cycle. And that's the focus. Now, having said that, commercial real estate in January has performed extremely well. It's been one of the best asset performers because they got beaten up so much. But still, we think it's quite a risky environment because in a slowdown that could be an area that continues to see some weakness.

Sam Benstead: Gilts have been a very popular investment on the ii platform, lots of people buying them directly. Is that part of the market you invest in and which type of gilts do you own?

Bryn Jones: In the Ethical Bond Fund, we can only buy green gilts. So, we've got the 2033 and the 2053 green gilt. They're the only two issued by the Debt Management Office. We're aware of that from our discretionary business as well, there was a lot of investors sat on cash accounts not earning a great deal, and they could pick up yield from buying the gilt. But also some of the low coupon gilts have been very tax efficient and we've got one maturing at the end of January, which has just a 0.125% coupon.

For a higher-rate taxpayer, that's just 0.06% of income tax and their CGT-free and income tax-free on the rest of the earnings. So, we understand that there's been that demand for it.

One thing that we've noticed is that a lot of the gilt purchase has been sub-five years, in low coupon stuff. And what we would say is the only risk about doing that is that you're locking in yield at a sub-five year area and should interest rates fall, you're not going to benefit from the capital appreciation like you might do in a fund or a longer duration asset.

Sam Benstead: It's an Ethical Bond Fund, so what does that ESG (environment, social and governance) overlay mean in practice? And you mentioned you can't invest in straightforward gilts, non-green gilts. Is that a detriment to investors?

Bryn Jones: First, I'll answer the second part of the question: I don't think it's a detriment to investors. If you look at the performance of our fund, we've outperformed our peers for decades now. The fund was launched over 22 years ago, I've been at the firm 20 years this year in November, and if you go back to when I took over the fund, I think we're in the top seven funds in the sector, and I’m one of the only fund managers to still be at the same firm. So, I would disagree that having that ethical overlay has led to outperformance. And as I said, we can't invest in government debt because of the weapons and nuclear power.

But obviously, [there’s] a whole host of other assets which we can't invest in: tobacco companies and alcohol companies and companies that might be involved in pornography as a media, and there's a full negative screen, but we also have a positive screen. So not only are we just saying: "Well, we can't buy this company because it's doing something that we disagree with", what we're looking for is a company that's looking to make a positive contribution in some way to society, to the environment, or to social or gender equality. And so that positive application also helps in good, what we would say is sustainable, companies. Albeit the fund was launched 22 years ago before the UN Sustainable Development Goals existed. So, we don't necessarily say that it has to have a UN Sustainable Development Goal target for an individual positive contribution.

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

Bryn Jones: I do. I didn't in 2020 and 2021. I thought yields were looking quite expensive, but post-Kwarteng and Truss debacle in September of that year, yields rose to 7% on my fund and I was sat on a bit of cash. And so I decided to buy my Ethical Bond Fund. Stuart Chilvers, who runs the Rathbone High Quality Bond I Inc fund (a short duration bond fund), I've also got some allocation to that in my ISA because it had a very attractive 6% yield at the time. And recently we launched a new Global Sustainable Bond Fund. And I've bought some of that for my fund and for my kid's JISAs as well, because having a decent compound yield in there is quite attractive.

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

Bryn Jones: 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.