It is clear that 2016 will go down in the history books as a year of great change from a political point of view, but it also could be remembered as the end of the great bond bull market that has spanned the best part of three decades. 
A credit boom in the decades prior to the global financial crisis coupled with significant market manipulation from central banks since the crash (in the form of ultra-low interest rates and vast levels of quantitative easing) has seen bond yields fall continuously since the 1980s. In turn, this has led to almost unprecedented risk-adjusted returns for fixed income investors.
Over the past 30 years, for example, the FTSE Gilts All Stocks index has returned 893.15 per cent.
While that is narrowly lower than the return of global equities (as measured by the MSCI World index), gilts have posted a maximum drawdown of just 10 per cent over that time, which is four times lower than the largest potential loss delivered by equities.
The great bond bull market
Source: Kepler Partners
In more recent times, thanks mainly to action from central bankers, this trend has had knock-on effects for equity markets: ‘safe’, high-quality, dividend-paying stocks have been lapped up by ‘tourist’ bond investors looking for some form of acceptable income as yields have been driven to historic lows. As such, top-performing equity managers over recent years including Terry Smith and Nick Train owe much of their table-topping numbers to this bond bull market.
The end of an era?
However, this could all be about to change. Having started 2016 with another almighty drop, government bond yields have risen dramatically since August. In the case of UK gilts, this has been driven by Brexit uncertainty and the pound’s collapse (which, in turn, is pushing through higher levels of inflation), as well as a significant rise in US treasury yields – a trend which has been spurred on by the election of Donald Trump and his commitment to economic stimulus.
Though many have incorrectly called the collapse of the bond market for a number of years, neither of these two powerful forces (Brexit and Trump) are going to go away anytime soon, so it is fair to suggest that bond markets will continue to come under pressure.
Such a trend would mean a big upheaval to what has become the status quo and continuously rising bond yields (or just increased volatility in fixed income) would cause headaches for most investors – especially as the strong risk-adjusted returns bonds have delivered have created somewhat of an asset allocators’ paradise.
However, if we are indeed at the beginning of a new era for markets, our research shows that value investing – a style that has been out of favour for the past decade – may witness a significant revival (a trend which has already started to a certain degree).
Indeed, we have analysed a number of value trusts that have significantly outperformed during periods of rising bond yields in the past and we believe can continue to benefit if this trend starts once again.
Value’s big resurgence
The value style had suffered over the recent times thanks to this period of ultra-low bond yields combined with an overarching sense of nervousness that has continued to dog investors since the global financial crisis, causing sentiment to remain low to those more cyclical businesses that litter the various value indices.
On the other hand, growth investing has been very much in favour as the market has rewarded companies that can grow in what has been a low-growth world, but also because ‘growth’ indices include those so-called bond proxies (companies with dependable earnings and a safe dividend) which have benefitted from the bull run in fixed income. The MSCI UK Growth index’s top 10 constituents include top performing ‘Steady Eddies’ like Diageo, Unilever and Reckitt Benckiser, for example.
Values’ woes
Source: Kepler Partners
However, we have analysed the relationship between these two investment styles during periods when bond yields have risen in the past and the results show that, if bond prices continue to fall, value could continue its big resurgence.
For our research, we looked back at that the 19 periods (priced daily) over the past 20 years (to the end of December) when 10-year UK gilt yields have risen more than 20 per cent and analysed the performance of the value indices versus growth and all-encompassing indices.
According to our research, the MSCI UK Value index has beaten the MSCI UK Growth index in 12 of those periods and has beaten the wider MSCI UK index in 13 of them. That is, of course, not outstanding.
However, as the chart below shows, over those 19 periods on average, the value index has doubled the return of the growth index (with an average gain of 6.34 per cent), beating the UK wider equity market by a decent margin in the process.
Performance of indices when gilt yields have risen by more than 20 per cent
Source: FE Analytics
It is a similar story when we analysed the performance of the respective MSCI AC World indices.
The bigger the bond market sell-off…
Interestingly, though, value’s outperformance has only been marginal when gilt yields have risen by 20 per cent to 30 per cent.
Performance of indices when gilts have risen 20 per cent to 30 per cent
Source: FE Analytics
This has happened in nine of the 19 periods we analysed and, on average, the MSCI UK Value index has returned 4.44 per cent compared a gain of 4.24 per cent and 4.37 per cent, respectively, from the MSCI UK Growth index and the MSCI UK index. In fact, from a global perspective, the MSCI AC World Value index has narrowly underperformed the MSCI AC World Growth index on average over those periods.
Instead, it is when the bond market has completely fallen out of bed that value investing has really come into its own.
Over the 10 periods when UK gilt yields have risen by more than 30 per cent, the MSCI UK Value index has outperformed growth in seven of them, returning 8.06 per cent on average. This compares to a return of 5.79 per cent from the wider UK equity market and a meagre gain of just 2.28 per cent from the MSCI UK Growth index.
In our view, this shows that allocating to the value style is one of the most effective ways for investors to shield themselves from further bond market routs.
These periods also include the most recent spike in yields caused by Brexit uncertainty and ‘The Donald’. Between September and late December, 10-year UK gilt yields rose by 95 per cent (from 0.74 per cent to 1.45 per cent) and, thanks to increasing correlations between the growth index and bond markets (0.54 over 12 months, compared to -0.08 over 10 years), the MSCI UK Growth index lost 4.19 per cent. The MSCI UK Value index, on the other hand, returned 6.49 per cent.
Performance of indices when gilt yields have risen more than 30 per cent
Source: FE Analytics
This performance pattern is again reflected from a global perspective (albeit it by a smaller margin) with the MSCI AC World Value index outperforming by a decent margin over the periods when bond yields have risen dramatically.
Getting the most out of value’s resurgence…
Value’s revival started in February last year as areas such as mining, oil stocks and banks rebounded from a painful 2015 and another sharp sell-off in January 2016, while those popular defensive growth stocks (or bond proxies) have already endured a painful few months.
As such, many investors may look to allocate to a cheap value ETF to take advantage of this trend. However, as a part of our research, we found that certain active managers with a clear value-bias have managed to deliver far superior returns to the index during those periods of rising bond yields such as Fidelity Special Values, Aberforth Smaller Companies and British Empire Trust.
It is not usually our forte to call the future direction of markets and while we see various reasons why bond yields will continue to rise, we are cognisant that fixed income has surprised many an experienced investor over recent times.
Nevertheless, we are of the view that these trusts can deliver strong long-term returns from here given they have all faced a significant style headwind over recent times which appears to be dissipating, are holding assets that are cheap relative to the wider market and have disciplined and tested investment approaches.
Alex Paget is a research analyst for Investment Trust Intelligence. The views expressed above are his own and should not be taken as investment advice.