Fixed Income  

Going against the grain

Winston Churchill once said: “It would be a great reform in politics if wisdom could be made to spread as easily and rapidly as folly.” The similarity here with investing is uncanny.

As we entered 2014, conventional wisdom held that, in anticipation of higher official interest rates, core government bond yields would rise from their historic lows. It all made sense: national deficits were still too large, borrowing remained too high, and – most worryingly – the central banks were keeping yields artificially low by buying more than their governments issued. But even as UK and US central bank bond-buying programmes slowed, the rise in yields did not happen. They have actually fallen in most instances, rendering the “wise” majority wrong.

To help understand why this might have been the case, it is worth remembering an all-too-often overlooked fact: bonds have inherent demand. There will always be a significant amount of buyers because people will continue to need income, and liabilities (of which there are still many) still need to be matched.

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A seismic shift in Western investors’ investing patterns has been occurring. Sweeping regulation in the insurance and pensions market has resulted in one-time changes in asset allocation patterns; insurance companies now hold the highest proportion of their assets (circa 60 per cent) in bonds and the lowest proportion in equities. Pension plans at many companies have been de-risking and general liability-matching strategies that inevitably require buying many bonds.

What is more, ageing developed-world populations will ensure a steady stream of fixed-income buyers as they seek to secure reliable retirement incomes. Diversification is another reason, with standard risk-modelling tools also continuing to recommend fixed income as part of a balanced client portfolio. The fact that bond returns are typically negatively correlated to equities means their inclusion within a portfolio offers a useful – and in the long term – necessary, balance.

Last but not least, central banks worldwide continue to have an insatiable appetite for their own government’s bonds. While the US Federal Reserve has backed away from further buying – at least for the time being – other banks such as the ECB and the Bank of Japan have doubled down given weak growth outlooks and even weaker inflation expectations.

Of course, this does not mean that yields will not start to rise, and that fixed-income markets will not come under pressure. That view would be naïve. It just means that the path upwards is not predetermined, and is unlikely to be smooth and straight.

Many a career (and fortune) has been wrecked based on the logical conclusion of undeniably overvalued government bonds, positioning portfolios accordingly only to find that they stay overvalued, or worse, become even more expensive. After all, while the origin of the quote “the market can stay irrational longer than you can stay solvent” is contentious, the sentiment certainly is not. Perhaps it was the economist John Maynard Keynes who first said it. In which case, his reminder that “in the long run we are all dead” might provide some light relief here.