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Home > Investments > Fixed Income

By Azim Meghji | Published Aug 20, 2012

Coping with high valuations in bonds

Fixed income assets have historically been considered lower risk than equities and with this lower volatility has come the expectation of lower returns.

This has been turned on its head so far this century, with both UK gilts and sterling corporate bonds outperforming the FTSE 100 index. Bonds have been all the rage or at least have been in vogue in this period.

This, however, raises some questions about the expected returns for bonds, specifically core government bonds, given their historically low yields. Surely there is only one way yields can go and, when they do, surely there is little that traditional fixed income fund managers can do to protect the capital value of these investments?

Current state of bond markets

At the moment, government bond markets are at extreme ends of the spectrum. First, there are those that are considered ‘core’, such as the UK, the US and Germany, which are perceived to be issued by ‘safer’ government issuers and can borrow at historically low levels. Some governments are even charging for the privilege of lending to them.

At the other extreme, there are bonds issued which carry the full faith and guarantee of governments which the market has little or no faith in. Among these borrowers – which markets and rating agencies historically considered to be almost risk-free – yields are at or near post-euro highs.

There are strong arguments to be made for higher core government bond yields. A common statement heard in fixed income markets is that ‘yields are bound by zero’. Although it is known that this is not technically true, as recently seen with German, Austrian and Swiss government bonds with a short period until maturity, it is still the case that we would not expect this to occur across debt maturing at a full range of dates.

With a majority of UK government bonds yielding less than the current level of inflation, there appears to be a strong argument that UK government bond yields will be higher in the medium term. This, of course, is the likely scenario – simple maths says that there is more scope for yields to increase than to fall.

However, what is lost in this argument is that the medium term can be a long time – just look at Japan by way of example. And while the UK might not be like Japan, the situation there seems to become a more pertinent case study as time passes.

Japanese government bonds have remained at ultra low levels of yields for many years amid high levels of government bond purchases, low levels of economic growth and low to negative inflation. Although we do not tick the deflation box, it all sounds remarkably similar.

UK gilt yields

Government bond yields are being kept at historically low levels, not just due to aversion to risk, but as a result of the Bank of England’s programme of creating money and purchasing assets – otherwise known as quantitative easing.

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