Bond investors need better valuations and more differentiation in risk premiums to make the asset class attractive again.
With yields close to their all-time lows, we are all aware of the risk of losing money at some point in fixed income. The combination of looser fiscal policies to meet the demands of a rowdy electorate, a stronger global economy and an end to super easing monetary policy will push yields up. This week has provided a taste of what might be in store for global bonds when, and if, central banks other than the Fed, do start normalising policy. The conclusion has to be that we will see better levels to invest in bonds in the future.
Taking away the punch bowl
Financial markets clearly don’t like the idea of liquidity being withdrawn. That has to be the lesson learnt this week as both bond and equity markets moved lower in the wake of comments from the Bank of England (BoE) and the European Central Bank (ECB) that gave hints about the first steps on the road of “opportunistic normalisation”. The move in bond yields has been quite remarkable. Benchmark 10-year bond yields are up over 30 basis points (bps) in the UK (from recent lows), 25 bps in Germany, 20 bps in the US and even 4 bps in Japan. Equity indices are down between 0.5% (Dow Jones) and 3% (German DAX) over the week. The moves follow comments from central bankers in Europe that suggest they are quite keen to follow the US Federal Reserve (Fed) in starting to unwind some of the massive monetary accommodation that has been very supportive to financial asset prices over the last few years. The bigger picture is that this is one of three macro trends that could dictate interest rate levels and financial market volatility in the future. Apart from monetary normalisation – the ending and partial reversal of central bank balance sheet expansion and extremely low interest rates – we have to also take on board the implications of the impact of the populist revolt against austerity and inequality on policy and the fact that we are seeing a broad based economic expansion. At the same time, bond markets have recently been trading at their most expensive levels since the crisis. Low yields and three large macro trends that are bond bearish suggest that higher yields/volatility may be the theme of the summer.
Not much yield protection
Earlier in the week I was doing an assessment of bond market valuations, looking at the “value” of the carry trade (holding bonds and earning the coupon income) across many sectors. The results were sobering. Very simply, total returns from bonds comprise of the carry (the income you get from the accrued coupon payments) plus the change in price of the bond. Price changes are driven by the volatility of interest rate expectations and credit risk assessments. A good carry trade means that the interest income is sufficient to offset any negative price movements. One way of analysing the attractiveness of the carry trade is to calculate the “break-even” yield movement that would negate the positive return coming from income. This is generally quite low given that yields (the carry) are at or close to their post-crisis lows in many parts of the bond market. For example, take a 10-year bond with a yield of 1% and a duration of 8 years and consider a holding period of 1-year. The 1% return coming from the yield would be totally wiped out if yields rose by just 12.5 basis points over the period. The second part of the assessment concerns the likelihood that yields would rise by an amount that would wipe out the return earned from the carry. In order to get an idea of that I looked at the 1-year volatility of yield changes across various bond sectors. Comparing the “break-even” yield change with the recent volatility of yield changes gives a sense of the attractiveness of the carry trade.
Risk of negative and more volatile returns
The analysis shows a lack of attractiveness across many bond sectors. For huge parts of the market the level of yields provided little compensation for the risk of losing money through the impact of higher yields – yields would not have to rise by much to wipe out the return from the carry and the amount that yields would need to rise was well within the range suggested by the scale of yield changes over the last year. The only parts of the bond market that provided positive compensation were short dated investment grade bonds in the US, and lowly rated high yield bonds in the US and Europe. In fact, the US market provides most of the value given that yields incorporate the tightening already done by the Fed. At the bottom of the value league stands the German and Japanese government bond markets. This is not surprising – yields are negative or extremely low. Indeed, when you face negative yields you are already behind in terms of total return so to give a positive total return yields would have to get even more negative (don’t think about it too much, it makes your brain hurt). As of last Friday (23rd June) the 12-month increase in yields that would have wiped out the carry from owning bonds was 25 bps in the 10-15 year part of the US market and just 12 bps in the UK. The market has moved more than that in the last 3 days! The bottom line is bonds are extremely expensive; yields offer little interest rate risk premium and in the credit market it will not take much of an increase in credit risk premiums to see deliver underperformance relative to government bonds. Nothing new here but important to refresh the assessment of valuations every now and again.
A long and difficult road to the exit
Bonds are expensive. Increases in yields will deliver negative returns. There are three macro themes that can force yields higher, or at least increase volatility. The first is the normalisation of policy. This is likely to be the dominant force in the short term as it is clear that communicating on the exit policy is not easy. Central bankers appear to believe that they are winning the war on deflation and also that they need to restore some firepower in readiness for the next downturn. This means having the ability to cut interest rates and not resorting immediately to further balance sheet expansion and in order to be able to cut rates they need to raise them first. However, markets don’t believe them – or at least doubt the reasoning behind a more hawkish stance. If central bankers persist in guiding investors to expect higher rates and less quantitative easing, then market yields will rise. The last week has given us a taster of that.
Some hope the cycle softens the blow
The second macro theme is the cycle. There is optimism about the global economy. The recent wobble in oil prices was not a sign of flagging demand but a result of too much supply, a theme that is repeated in other commodity markets. Global growth is expected to remain reasonably strong going into next year and a lot of bottom-up anecdotal evidence is that the pick-up is really gathering steam in continental Europe. Almost everywhere, unemployment rates are falling and despite inflationary expectations remaining very low there is clearly a risk that reduced spare capacity and tightening labour markets will eventually cause inflation to rise (notwithstanding the longer term disinflationary forces that I have discussed in recent weeks). Bond yields remain much lower than the rate of nominal GDP growth and that gap could close.
Policy mix changing
My final theme is less easy to be very specific about as it concerns politics. The last few years have seen a discernible increase in what is described as “populism”. To me this is a reaction to years of austerity and growing income inequality in western economies. It manifests itself in a desire for change, a reaction against “elites” and growing opposition to globalisation. The western liberal capitalist hegemony is at its weakest for a long time and traditional political elites are struggling to make the model appealing to younger and low income voters. Out of reach house prices, stagnant real incomes, a state that can’t meet the expectations of public provision and a lack of trust in the mechanisms of capitalism, especially the financial sector, are difficult realities to counter. You don’t have to be a revolutionary to see why many think that the prevailing model is not delivering and you don’t have to be a political scientist to conclude that mainstream politicians have failed to pick-up the pieces from the damage done by the financial crash of almost a decade ago. The demand for change has already had political ramifications – the election of President Trump, Brexit and the emergence of Emmanuel Macron – and I suspect that it will change the policy agenda for years to come. In the end money talks and we are likely to see some combination of increases in public spending and more progressive taxation. The generation that benefitted from the boom years of capitalism now face pay-back time. I suspect this means higher budget deficits as well, and the consequent increase in public debt that goes with that.
Bond markets have benefitted from the combination of fiscal austerity and aggressively accommodative monetary policies. That policy mix is starting to change, driven in part by the cycle, in part by politics and in part by the need to restore some level of normality. All things being equal it means higher bond yields. How high? Who knows. Given very strong structural factors and the slow pace of monetary unwind, it won’t be a massive move anytime soon. But as the analysis above shows, it does not take much of a move to crush returns to bond investors. For active bond managers such moves do have a silver lining in that they will improve valuations in the bond market in general, they will introduce more volatility and they will mean more differentiation of risk (the removal of the central bank bond put assures that). As you know I am a huge believer in the power of bonds to hedge risk and it is difficult to believe that a rise in bond yields won’t be followed by increased volatility in equity markets (the earnings cycle must be close to peaking). So, for bond yields, what go up will eventually come down again. Strap in and get ready for the ride.
Chris Iggo – CIO Fixed Income – AXA Investment Managers