The question for government bond investors

21st December 2010

The Bank of England in its most recent Financial Stability Report indicted that it considers it a key risk for the UK economy, both because it drives investors to higher risk emerging market bonds, threatening to create a bubble, and because ‘low risk' government bond investors may lose money.

The issue made the front page of the Times , which highlighted the central bank's warning that any reversal, "could lead to falls in asset prices and trading book losses for banks internationally" on the scale of the 1994 sell-off in government bonds.

As this Bloomberg article reminds us, Federal Reserve Chairman Alan Greenspan tightened six times in 1994, taking rates to 5.5% from 3%. The return on Treasuries fell 3% as a result, the first annual loss in a quarter century.

But is this simply scare-mongering, as one poster on the Citywire website responds to this article? . After all, there are good reasons to suggest that yields could move even lower than their current level. Government bond yields have been on a declining trend for two decades, they remain supported by quantitative easing and the Eurozone is likely to resume monetary loosening policies next year. Most policymakers believe that underlying inflation remains under control and the consensus expects interest rate rises to come no sooner than 2012.

However, on the flip side, government support cannot remain in place forever and there is little evidence that other buyers for developed market government bonds are emerging. Any nascent bubbles in the emerging world may have a knock-on effect for inflation in developed markets and rates will have to normalise at some point. This suggests a likely rise in yields. None of these things have to be in place for yields to begin rising – markets will respond on fears.

Bond investors are effectively playing a game of brinksmanship. They know it must happen, but do not know when. Many have moved out into longer-dated bonds to provide higher yields, creating more interest rate sensitivity. However, others are already making their moves: John Whipple, an adviser posting on the Citywire site says: "I am glad I have been selling bonds all year as the bond run is at an end for the time being. Interest rates cannot rise for a good while as there are still huge problems for the west but inflation is not going to fall away in fact it will continue upwards we could see CPI at 4.5% next year possibly higher but that is part of the plan to erode the debt.

"So to obtain a return for clients we need 4.5% plus a margin and for that you have to decide where the real risks lie and in what ratios they should be holding that risk. We are in interesting times as conventional asset allocation models might be saying this is a lower risk asset (historically true) but in today's "uncharted" waters it may well turn out to be a very high risk asset holding. We saw this in 2007/ 2008 with EM equity V's Developed nation equity and we might see it with developed nation Bonds this 2010/2011."

In the end it comes down to a balance of risks. It is investment good sense to buy when there is a greater chance of making a good return than making a loss. The question for government bond investors is whether that balance of risks is now on their side.

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