Lastest news

Five reasons to be fearful for the bond market

May 17, 2018
Traditional fixed income markets face a number of challenges over the coming year. With the potential returns from the highest quality bonds in the developed world and the fact a competitor asset class appears - again - to be offering superior returns, there are a few reasons to be wary of the bond market.

Inflation and interest rates starting to rise

Inflation is creeping higher and higher. For the last decade, deflation or disinflation was the dominant theme. Now, as the economic recovery has spread to so many core countries, energy and metal prices are lifting again, and the numerous pools of spare skilled labour across the world are reducing in number and size. Each small increase in inflation expectation causes a bigger increase in bond yields and falls in bond prices. Buying inflation-linked bonds, designed to protect from rising levels of inflation, may not be the answer as prices are also affected by supply/demand factors and the level of nominal yields. What one gains on predicting rising inflation might be smaller than the losses from rising conventional yields.

Also, policy rates are starting to move up, pulling yields higher across much of the developed world, led by North America. After years of interest cuts, most central banks have reached a nadir. Bond markets will lose the tailwind that they have enjoyed, off and on, for over 30 years.

An end to QE

The extraordinary purchases that central banks adopted are slowing, have stopped or are being reversed. US Treasuries have sold off, partly due to one of the biggest buyers turning into a seller. The prospect of reduced buying by the European Central Bank (ECB) has driven European government bond yields higher; the ECB’s quantitative easing (QE) programme was huge in respect to net bond issuance, and vast relative to the size of the US QE plan in that regard.

To add to that, the level of yields for high quality bonds is not at all high. Many trillions worth of bonds still offer negative yields to maturity. Even with positive yields, the quantum is rarely high compared to the last five decades. There is little or no margin of safety in these assets. Given that bonds have a terminal price, holding bonds with a negative yield to maturity is a guarantee to lose money in nominal terms, to lose more if there is inflation and lose yet more if there is a default.

One common answer to all four of the above concerns is to buy short bonds (go short duration, in market speak) or buy funds that do short duration. Shorting bonds (selling bonds with the right to buy them back in the future) whose yield is negative might be a far cheaper exercise than ever before and, where yield curves are flat, there is little extra cost.

The equities challenge

Finally, there is the number one competitor to bonds: equities. 2017 saw equities beat bonds again, by nearly 20% in total return terms in the US, and for the sixth year in a row. German bonds were the laggard, starting as the most unattractive yields and finishing there too; yet the DAX made over 12% in local terms. In principal emerging markets, buoyed by generally stronger currencies, many bond sectors did well but equities mostly did better. The growth outlook for the next few quarters is remarkable, and is sufficiently robust to help lift corporate earnings in most industries despite rising wages and raw material costs. Dividend yields still look great compared with bond yields from the same quality company.

Tim Haywood is an Investment Director Business-Unit Head for fixed income at GAM Investments.

This article was first published on www.thefmreport.ie

This article is the personal opinion of the author.