“My two strongest convictions are that sovereign bonds are really attractive and that investors need to be cautious with risk. Risk markets are ignoring all kinds of problems, potential shocks, and valuation issues.” These are statements from Ben Lord, fund manager at M&G Investments. Lord was one of the spokespersons chosen by the firm to celebrate 20 years of Bond Vigilantes, in a series of conferences held in Madrid. In an interview with Funds Society, Lord expressed his view that investors should maintain long positions in sovereign bonds, especially from the United States and the United Kingdom. “If we analyze returns across all fixed income, 75-80% of the opportunity comes from sovereign bonds,” he asserts.
Why sovereign bonds?
Sentiment toward sovereign bonds is terrible. Central banks have missed their inflation targets for five years. Governments are not cutting spending or raising taxes enough, and they continue to spend more and more. That means they have to issue more and more public debt, and that is the context we find ourselves in. This is the current market environment.
So, do you find sovereign bond yields attractive?
In our view, it all depends on valuation, and with bonds above 3.5%, British bonds above 5.5%, and Treasuries above 5.3%…, these are levels where we see long-term value. We believe that the nominal yield on the 10-year sovereign bond should essentially sit around the average level of nominal GDP. That is, 2% inflation plus real GDP growth of 1%-2% over ten years. That means that when we are above 5% in the United States and the United Kingdom, these levels start to look interesting.
In the United States, one could say that today inflation is at 3% and growth is at 3.5%. That implies a nominal GDP of 6.5%. Therefore, one could argue that 10-year Treasuries do not offer a good valuation. I would say it is quite difficult to expect that for ten years inflation will remain at 3% and U.S. real GDP will continue growing at 3.5%. I think both levels will probably come down. In the United Kingdom, inflation is at 3%, but real GDP is between 1% and 2% and is declining.
I know there are risks. But when you analyze 10-year sovereign bonds, you have to keep in mind that there will be changes over the next ten years. That is why we see value, as we consider that if we assume 2% inflation and 2% real GDP growth, 4% is roughly the level where we should be neutral. And we are well above that level in both the United Kingdom and the United States. In Europe, we believe inflation will probably settle at 2% and real GDP around 1%. Therefore, we have a nominal GDP of 3% in Europe, while 10-year bonds are at 3.6%.
How long can these levels persist?
If the cost of a government’s debt is higher than its nominal GDP—that is, its potential growth—in the long run borrowing at those levels will have consequences for the economy because funding becomes very expensive. More and more money will go toward interest payments, which takes resources away from other areas. Ultimately, high debt costs reduce potential growth. That is why we believe it makes sense to maintain long positions. It is also very easy to say that governments are simply going to borrow more and more and that we will end up entering a crisis. That risk exists. And I think many people are comfortable holding short positions in duration and in sovereign bonds. But they are relying on the idea that, when the crisis comes, they will be able to switch to long positions in duration.
That sounds fairly complicated
It is impossible. I have never been able to time the market. I have never met anyone who can. I would really question anyone’s ability to maintain a short position right now. The crisis can hit any day. And when a crisis hits the sovereign bond market, what happens? Governments have to cut spending. They have to raise taxes. They are forced to do it quickly and aggressively. Let’s go back, for example, to 2011-2012, with the sovereign debt problems in the European periphery. It was very easy to stand there holding short positions and think that there was nothing anyone could do. But Mario Draghi came along and said he would do “whatever it takes.”
And look at everything that happened afterward… What we are saying is that yes, it is scary. Yes, it has hurt. Yes, it has been a bad few years as yields have gone up. But you have to maintain long positions if you want to benefit when the moment comes, when governments get the message, when a bailout is required, or when a failed auction occurs. Suddenly, governments will have to fix it. And on that day you need to be long.
Do you think central banks are closer to committing a monetary policy error?
What I find interesting is that we have a supply shock in oil. It is caused by a single person. That is a tax on consumption. Between 2022 and 2024, everyone had a lot of savings left over from the pandemic. Those savings have already been exhausted in the United States and the United Kingdom. In Europe there is still a fraction left, but it is much smaller than two or three years ago.
Real wages are now growing between 2% and 3%, while average real disposable income is growing between 0% and 2%. Therefore, we are not in a particularly strong consumer environment. Now we have a tax in the form of higher energy and fertilizer costs. And El Niño. All these factors act as a tax on consumption.
And now, since central banks have taken five years to bring down inflation, the bond market is saying: you have had enough time. If you do not bring down inflation now, the bond market is going to react. For that reason, I get the sense that the bond market is regaining control. But if we combine more expensive energy, potentially more expensive food and fertilizers due to other related global events, and now we also raise interest rates because the bond market needs inflation to come back down after so much time, yes, there is a clear possibility that central banks will overtighten monetary policy.
What are the chances of a recession occurring?
In risk markets, I get the feeling that the probability of a recession is practically 0%. It is enough to look at where stock markets, credit spreads, and valuation differentials are. But if we are tightening monetary policy for governments, companies, and households while at the same time all of them are facing these cost-of-living pressures, there is a high probability that the tightening occurs at the worst possible time, when demand is falling.
Is there a risk of a fiscal policy error?
If excessive tightening occurs, there is a possibility that we have a consumer recession. The traditional economic policy response over the last 40 years to a slowdown has been to announce large spending programs. Now there is a higher probability than there has been in a long time that the bond market would react negatively to that kind of fiscal easing.
But that is not my central scenario. If we enter a slowdown, there is one thing I do know: central banks will cut rates. They will cut them aggressively. Therefore, my view would be that if we enter a recession, stock markets will fall, credit spreads—both high yield and investment grade—will widen, and what will investors buy? They will buy sovereign bonds. If a negative reaction occurs in the bond market—and it is not my central scenario, but it is something we have to consider—perhaps one would need to be more cautious with long-maturity sovereign bonds. To me, that would be a term premium shock.
So, what would you do in the event of a recession?
Generally speaking, I would be bullish on sovereign bonds and duration if we ultimately enter a slowdown for any reason. But beyond that, if rate cuts or hikes occur more aggressively, that could generate a really strong shock.
My first reaction is to think that, in a risk-averse scenario triggered by a recession, investors will flock to sovereign bonds. They are the cheapest assets I see. But we have to accept that a tail risk exists: if politicians react to a slowdown or a recession aggressively and announce a lot of public spending, the bond market might not welcome it. Therefore, I would start favoring 2-, 5-, 7-, and 10-year sovereign bonds, and I would be more prudent with 20- and 30-year sovereign bonds.
