Fixed IncomeNov 12 2015

Following the yield curve in the search for income

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Since the start of the global financial crisis in 2008, investors have flocked into bonds. Flows into bond funds have outpaced flows into equity funds in the last four of the past six calendar years, as is shown in Chart 1.

This is remarkable, as equity markets have more than recovered since 2008. The returns of the MSCI Europe have been positive in every calendar year since 2009, with the exception of 2011. Behavioural finance offers an explanation called “availability bias”, which explains how our thinking is strongly influenced by what is personally most relevant, recent or dramatic to us.

Clearly, 2008 has been lingering on the mind of investors. These large flows into government bond funds have resulted in very low yields, specifically in bonds from safe haven countries, such as the US, Germany and the UK. (There is an inverse relationship between bond prices and yields, so if demand for government bonds increases; prices of government bonds increase and yields go down).

To understand interest rates and bond yields better, we need to interpret the yield curve. A yield curve is a line that plots the interest rates of bonds with different maturities, but with equal credit quality at a fixed point in time. The shape of the yield curve therefore tells us what the market expects in terms of future interest rate changes and economic activity. Traditionally, central banks have controlled the short end of the yield curve with the policy rate (for example, the Federal Funds Rate set by the Federal Reserve in the US or the Bank Rate set by the Bank of England in the UK) while the market has determined the longer end of the yield curve, based on, for example, inflation expectations, GDP growth, supply and demand and risk appetite in the market.

Since 2008, however, central banks around the world have tried to exert influence on the longer end of the yield curve, by means of various so-called quantitative easing programmes. The Fed, for example, has made large-scale purchases of mortgage-backed securities, agency debt obligations and longer-term treasuries during three QE-periods from December 2008 until October 2014, in an effort to also keep longer-term government bond yields low. The Fed is now the largest holder of US government debt, owning roughly $4.2trn in assets, as of the end of December 2014.