The difficulties in getting a good return from Western nation bonds.
The great crash of 2008-9 has left interest rates in much of the advanced world at very low levels. The fitful and slow recovery this decade has meant central banks have needed to keep rates low. Japan had a similar, if even more dramatic, experience after its spectacular share and property crash at the end of the 1980s, and still today has interest rates around zero.
The result of setting low interest rates has been high bond prices. Indeed, the central banks of the US, Japan, the Euroarea and the UK set about creating ultra-low income rates on bonds by buying up large quantities of these bonds for their own portfolios, so we had low rates for long term lending to the government as well as low short-term official rates. It means investing in advanced country bonds is now not very rewarding, with a low running yield and limited prospects for any capital gains from the current prices. Only if we went back into recession and central banks had to initiate major bond buying programmes again could you anticipate a further major move from dear to very dear for these bonds.
It is true the US has detached itself from the rest of the advanced world by increasing official interest rates and cancelling some of the bonds it had bought up during the early recovery days. The US Federal Reserve has switched from quantitative easing, buying bonds with created money, to allowing the bonds to be cancelled when they are repaid, reducing the size of its balance sheet. Its policy is to run off $30bn of Treasuries each month. This lies behind the higher yields you can get on US Treasuries than on European or Japanese government bonds. In the sell-off in markets at the end of last year, part of the worry arose over the pace at which the Fed is cutting its support for markets. As its balance sheet assets reduce, so too do its liabilities. These are mainly the reserve deposits of the commercial banking system placed with the Fed. The danger is if the Fed cuts its assets too fast and too far the commercial banks will not be able to finance a vigorous recovery for the economy.
The Fed has backed off this year, saying it will be patient over any future interest rates rises, and saying it is looking again at the pace and length of its programme of reducing its bond holdings. As a result, the worst fears of the pessimists have been blunted. On the basis of running income and valuations US government bonds look much better value than European or Japanese bonds. Investors are adjusting to a world where 2.5% is a good rate of interest on a ten-year bond, compared to pre-crisis when people might have had 5% in mind as more normal. It is interesting that you can get a higher income on a 10-year US bond than on a 10-year Italian bond, given the worries about Italian debt levels and the turbulent relationship of the Italian state with the Euro scheme.
If you were the proud owner of a 2% government bond with no repayment date, the ultimate ultra long bond, when interest rates fell to 1% from 2% your bond would double in value. The fixed annual 2 dollars of interest on a $100 investment in such a bond giving you an income of 2% would mean a doubling of the price to get the fixed income of $2 down to just 1% of the value of the bond. You would make more money in a long bond than in a short bond. If you had a one year bond at 2% and interest rates went to 1% the bond would only rise roughly $1 to $101, so your $2 income in the year would be reduced by the $1 loss you made when the bond you paid $101 for repaid at the end of the year for its issue value of $100.
These characteristics of bonds mean that when specialists think interest rates will rise they tell you to only hold very short dated bonds or cash, to avoid the bigger losses in long bonds, and when they forecast interest rates will fall they suggest you should take the risk and hold longer bonds. Bond specialists also tend to the view that if the income on a long bond is similar to the income on a short bond it means there are fears of recession around the corner. The market is expecting as the economy goes into recession the central bank to have to cut short-term interest rates to relieve the squeeze on borrowers and the wider economy. This would restore a more normal relationship between income yields on long and short bonds. Normal is thought to be a higher income on the long bond to reflect the risks of greater losses and to reward you for locking up the money for longer.
Today, though, we need to ask is it any longer normal to expect extra income for lending for longer to western governments? As recently as 2014 a bond buyer got 2% more income by buying a ten year US bond rather than a 2 year one, 1.3% more on a German ten year than a two year, and even 0.5% more on a Japanese ten year. Now there is little difference in yield between the two and 10-year Japanese bond, just 0.2% difference for the US bonds and around 0.7% for the German bond. This may not be the markets saying there will be a recession. It may just be the result of plenty of money having to be placed into bonds by insurance companies, pension funds and others who cannot afford to take more risk by buying shares instead. This buying has taken over from official Central Bank buying to keep long bond prices up. They seem to buy longer dated bonds for very little extra income, on the grounds that something is better than nothing. It also signifies they do not expect a general rise in interest rates any time soon.
Sovereign bond markets are relatively calm, with less volatility. This will remain true all the time market opinion thinks the main Central banks will avoid new rate rises, and all the time those same Central Banks go carefully about trying to get back to an old normal. Today US Treasuries give you the best income without the special Euro risks and without the ultra-low flat yields of Japan.
Some people conclude from this they should take more risk in bonds in other ways. They can opt to take credit risk by lending to companies, or move into emerging market sovereign debts. I will look at the pros and cons of doing this in ‘Is corporate debt worth the risk?‘
The above article was previously published by Charles Stanley on 20th March 2019