Global government bonds are substantially cheaper than in recent years, but they are still expensive, according to Robeco.
The Dutch asset manager looked at three ways to measure government bond valuations in major markets, including the UK and US, and concluded that overall, the price of global government bonds had fallen substantially as yields rose, but they were still considered "expensive".
In its report, 'Expected Returns 2023-2027: The Age of Confusion', it said: "Global investors saw the nominal value of their holdings fall by more than $25tn in the first half of 2022, wiping out over 15 per cent of their portfolios.
"To some extent this is not surprising as our signals have been indicating that assets have been overvalued for years.
"We have looked at three different ways to measure government bond valuations in the five main markets. Our conclusion is that overall, global government bonds have become substantially cheaper than they have been in recent years, but they are still expensive."
Robeco assessed the valuation of the major government bond markets according to three metrics: carry, the term premium and mean reversion.
Carry represents the return government bonds would provide should the interest rate curve remain unchanged. Sometimes called the term spread, it is often defined as the 10-year yield minus the one-year yield.
Robeco assumed an excess return of government bonds relative to bills of 0.75 per cent per year, meaning a carry substantially higher than this would be seen as attractive, and a lower carry as unattractive.
On June 30, when Robeco pulled the data, the US carry was 0.21 per cent, indicating that bond yields were relatively expensive. German yields were rather low but the carry was more attractive at 0.92 per cent, similar to the 0.95 per cent carry for Japan and the 0.89 per cent for China.
The carry for the UK was low at 0.38 per cent.
Robeco then looked at term premium, which is the additional return an investor expects to receive from holding a government bond to maturity rather than rolling over bills until the same maturity.
A term premium of zero indicates that investors expect the same return from investing in bonds as in bills.
Robeco estimates that the 10-year term premium for the US was -0.17 per cent, based on the Adrian, Crump and Mönch model. This was much higher than in 2020, when it stood at -1 per cent, but still well below the 0.75 per cent premium the firm expects in the long run.
The 10-year premium for Germany was 0.42 per cent at the end of June 2022, while the Japanese term premium was 0.15 per cent.
Another popular way to look at valuation is to forecast a reversion to the mean, said Robeco, which did this by comparing the yield to its 10-year average rate.
The yield to maturity of the Bloomberg Treasury indices for the US and its 10-year moving average:
Following this method it determined that US, German and UK yields were above their 10-year moving average, suggesting these bond markets were currently relatively cheap according to this measure. Japan’s yield was very close to its 10-year average.
But they were still below the steady-state expected return of 4 per cent, making them "substantially cheaper than they have been in recent years, but...still expensive.
"Germany is slightly more expensive than the US. Yield levels and term premium estimates are still below their steady-state estimates," Robeco concluded.
The yield on the UK gilt has since surged to above 4 per cent for both the 10- and 2-year bonds in response to Liz Truss's economic policies and plans to borrow £72bn more through the bond markets before next April.
Robeco said the market movements in the UK yield curve in September have now changed the UK government bond valuation signal from "expensive" to "neutral".
Corporate bond valuations
When it came to corporate bonds Robeco said at the time of writing corporate bond spreads looked cheap, but they might not have fully priced in future economic conditions.
The global investment grade index’s credit spread was 170 bps at the end of June 2022.
Assuming that about half of the spread will be needed to cover losses due to default in an expected credit cycle, the expected excess return was close to the neutral steady-state level of 0.75 per cent.
Meanwhile, the global high yield index’s credit spread was 620 bps, which, Robeco said, meant it should be able to withstand substantial losses before reaching its neutral steady-state expected return of 1.75 per cent.
"So from a valuation perspective, high yield corporate bonds seem a little cheap, while investment grade credit seems to be fairly valued," Robeco added.
Earlier in September two fund managers explained why they believed high yield bonds could weather the storm of a recession better than many might expect.
carmen.reichman@ft.com
