How low can bond spreads go?
When investors look back in five or 10 years’ time they will be pleasantly surprised by the returns they have achieved from their fixed income investments.
This is not dissimilar to the past five or 10 years, when fixed income supplied impressive returns that few predicted.
The returns in the past decade were driven by central banks adopting inflation targets and then cutting interest rates to generationally low levels, which drove bond yields to unimagined lows. In the coming years, there will be a critical difference.
Today the central issue is debt. Before the financial crisis, households, companies and governments had built up extraordinary levels of debt, and now they are focused on paying it off. Dealing with debt will dominate the financial landscape for many years to come.
Deleveraging cycles take about a decade, and we’re only about a quarter to a third of the way through this one. This creates a positive environment for fixed income as the two biggest enemies for a fixed income investor – inflation and interest rate rises – are largely absent, and likely to remain so for some time.
Japan supplies a roadmap
For fixed income markets, there is a roadmap: Japan. Following the collapse of an asset-price bubble created by cheap credit, Japan in the 1990s faced many of the problems that other developed markets face today: a banking crisis and a prolonged period of economic stagnation, compounded by very high levels of debt. Its ‘lost decade’ has endured for 20 years.
The lesson of Japan suggests that there are several phases in the deleveraging process. In phase one, interest rates are cut to zero, or near-zero. In phase two, quantitative easing is used to bring the government bond yield down to a hitherto unimaginably low level.
The theory behind this is that the government bond yield represents the cost of capital. A low cost of capital stimulates economic activity, at least in theory, because it means companies and consumers can borrow at very low levels of interest. In the current deleveraging cycle we’ve passed through phases one and two, and are in phase three. In phase three, bond investors move out on the risk spectrum, into corporate bonds – both investment grade and high yield – and begin to take a more international approach to fixed income investing.
The rationale for the move into corporate bonds is simple. Bond investors are essentially money lenders, and, like money lenders, should be focused on the ability and the willingness of the borrower to pay them back. In general, companies currently look more creditworthy than governments, having focused since the financial crisis on paying down debt and strengthening their balance sheets. Corporate bonds also reward investors better, yielding roughly 2 per cent more than government bonds.