31st January 2015 by Chris Iggo
There seems to be an inevitability about lower government bond yields. People are falling over themselves trying to forecast just how low they can go, a process that has been made more difficult by the fact that some parts of the bond market have negative yields now. That means if you buy them today and hold them until maturity, you lose money. To me the real longer term concern is what this period of ultra-low yields does for the economy and what it means about how people look at fixed income in the future. In the absence of any great answers to those questions, I think high yield looks good. At least you get 350-500basis points more than in the government bond market.
How low can you go? – Bond yields grind lower almost everywhere. What has become increasingly clear is that the market is dominated by central banks. These institutions have never owned assets to the extent they do today with this set to increase further in the wake of the European Central Bank’s (ECB’s) decision to expand its own balance sheet. The statistics are telling. Central banks that have engaged in QE have balance sheets that range from 20% of GDP to 60% of GDP (Japan), while the Swiss National Bank’s (SNB’s) balance sheet had reached 80% of GDP when it decided to allow the Swiss franc to float against the Euro a couple of weeks ago. The planned ECB programme will lead to a reduction in the net supply of government bonds in the Euro area as the ECB will move towards owning up to 25% of the debt of some countries. The sheer size of central bank purchases and holdings, with the associated re-investment of coupon flows, is mind-boggling and goes a long way to explaining why many bond markets have negative short term yields and why 30-year borrowing costs are at record lows. In addition, central banks are underwriting deflation fears that discourage investors from taking an aggressive contrarian view on rates. The Federal Reserve’s (Fed) communication this week after the Federal Open Markets Committee (FOMC) remained pretty balanced on the issue of raising interest rates this year, while the Bank of England appears to have backed away from a 2015 hike in UK rates. It’s hard to really have any conviction – after being wrong in the past – about bond yields rising until there is some meaningful change in the way central banks operate. Either they stop QE or start to send more hawkish signals. Neither looks to be on the cards.
Pessimism on life– My view is that the message that one would infer from the level of yields in the bond market is one that is far too pessimistic about the current state and the prospects for the global economy given the facts. Growth is improving in many economies and the decline in global energy prices is, on balance, positive for real incomes, spending and investment spending outside of the energy sector. Even if low levels of inflation prevent wage growth picking up as strongly as it might, the fact that more people are in jobs (millions in the US) and that real incomes have been boosted is surely a much better position to be in than in 2011 when global commodity prices were rising and unemployment was going up. So I believe that the level of government bonds is not consistent with expected nominal economic growth and that the biggest risk to fixed income markets over time is a change in forward expectations about monetary policy and inflation. Again, that does not look imminent so bond yields are likely to remain low for some time. It also means prospectively low returns from bonds.
Lost their edge – It’s hard to see value in most parts of the fixed income market as a result of the level of yields and unless one has a very pessimistic view about life. I’ve also been thinking about the role that fixed income plays in many investors portfolios where bonds have traditionally been seen as diversification assets and something that acts as a volatility dampener for exposure to equity markets. Let’s go back to the beginning of 2012 and imagine an investor had a balanced portfolio of 50% UK equities and 50% UK corporate bonds in the form of a benchmarked corporate bond fund. At the time this would have had a yield of 5.5% with a duration of 7.8 years. Over the course of 2012 the yield fell to 4.0%, a decline of 150bp delivering a total return for the bond portfolio of over 15%. On the equity side the market delivered 5.8% return. But imagine if it hadn’t and there had been a sharp decline in the value of equities, perhaps because Draghi’s ‘save the euro’ speech had not worked or had been delayed. Just for arguments sake, the fixed income part of the portfolio would have cushioned a decline in equities for up to 15%. In other words, bonds were still able at that time to provide protection against a decline in equity values in a mixed portfolio. Today, the same corporate bond portfolio has a yield of 2.86 with a duration of 8.8 years. To get a 15% total return, the yield would need to decline by around 130bp. Given the prevailing spread over gilts, this would basically mean gilt yields going to zero. Clearly the same bond portfolio has less capacity to deliver the protection against a sharp decline in equities than it did a few years ago, simply because of the level of yields today. The investor would need to have even more duration in the bond portfolio to provide the protection (bigger capital gain for the same fall in yields) but that probably sits very uncomfortably with many investors who see rates going up at some point.
QE has given us all more risk – What QE has done and will continue to do in Europe and Japan, is push investors either into longer duration assets (to get the same diversification in balance portfolios) or into more credit risk (and therefore into those parts of the bond market that are more correlated with equities). The consequence of that is either more duration exposure and thus downside risk to rates going higher from their current all-time lows, or more credit risk that is positively correlated with equities and thus more downside risk should there be a significant equity correction. It is little wonder that many private investors and their advisors that I have been speaking with throughout Europe in recent weeks are very negative on fixed income as an asset class. My preferred asset allocation would be to take the equity exposure in a balanced portfolio and replace part of that with high yield fixed income and then have the fixed income part in a bar-bell of short duration credit and inflation linked bonds to provide the duration but also the hedge against a rise in inflationary expectations that could be a result of a large European QE programme. Another alternative is to have a very diversified approach to managing bond portfolios, one that does not over emphasis one part of the market too much, that is not governed by market cap weighted benchmarks and one that is flexible in managing the duration and credit risk. We have found that, over time, a diversified fixed income approach produces much better risk adjusted returns
Greece is not the central story in Europe – The ECB’s programme should get underway in March. The timing is interesting because we now have renewed questions about the sustainability of Greece’s membership of the Euro in the wake of last weekend’s election. On the one hand I am tempted to think that the rhetoric displayed by Alexis Tsipras during the election campaign will become watered down now that he is in office and faces the very realistic possibility of Greece going through even more turmoil if he turns his back on the European creditors. On the other hand, I worry about his politics. I saw on the BBC news that one of his first comments about policy other than the EU and austerity was an intention to ban all-inclusive holidays in Greece because they prevent holiday makers spending money in local bars and restaurants. Safe to say he will not be predictable and the electorate will be looking for wins from Tsipras and ways that Greece can ease its austerity going forward. For their part, Germany so far has not given any indication that it is willing to renegotiate Greece’s debt or its aid package. It could get interesting but I doubt it will derail the ECB nor lead to serious contagion to other countries. Investors do express concerns about anti-European political parties throughout the Union expressing a desire to reduce debt burdens by extensions or renegotiations. However, with Spanish 10-yr yields at 1.4% and Italian yields at 1.6%, the impact of QE on borrowing costs and debt relief is much more powerful over the longer term. Spain is now seeing the fruits of low interest rates and structural reform with the economy expanding by 0.7% in real terms in the fourth quarter of 2014, taking the full year GDP growth number to 1.5%. A massive expansion of the ECB’s balance sheet in a way allows the European markets to more easily absorb the volatility that could result from Greece but it also provides a huge blanket of comfort for staying in the Euro Area. With the currency falling, the ECB buying debt, banks stronger and economic growth showing signs of life the choice has to be to stay in.
Scenarios, for what they are worth – As part of the chart pack I have been using on my roadshows so far in January is an attempt to describe 3 possible scenarios for 2015. The one that is playing out so far is the one I called “We are all Japan – or more of the same”. More of the same in that central bank influence remains dominant and yields go lower giving the impression that we are, indeed, all going the way of Japan (which funnily enough reported an inflation rate in January of 2.4%). Under that scenario you can get positive returns from bonds, the longer the duration the more the return. It’s a difficult environment to invest in. Central banks want to buy lots of bonds and keep yields low. And I still can’t really formulate what happens if this is a scenario that still sits alongside positive growth. Surely central bank liabilities rising (money printing) will at some point lead to financial instability or inflation. The second scenario was the more likely one of monetary divergence as the Fed finally gives in to the inevitable and nudges rates higher. That leads to mixed returns in bonds. The third scenario is that oil price declines spur growth and central banks start to distance themselves from emergency monetary policy. Rates higher and losses from bond portfolios. The problem is it is hard to put much conviction on any of these scenarios. In the meantime, we comfort ourselves in liking US high yield because the yield is attractive and the US economy is strong and the Fed is still some months from raising interest rates. That market is up 3.4% from its low in December and probably has another 2-3% upside in the short term as spreads narrow. If you like equities, then like high yield too.