Fixed income has been the focus of much attention in recent months, with many investors concerned the bond bull market may be coming to an end. Market conditions have indeed changed – central banks are cutting back on quantitative easing (QE), inflation appears to be on the rise and interest rates look set to increase further.
However, the impact and extent of these changes are unclear. Taking a closer look at bond yields over time paints a more positive picture, and encourages investors to take a more strategic approach to the bond market.
Where have yields been historically?
Looking back at the evolution of the US 10-year bond yield over the past three decades, many investors will be surprised to see that it was close to 10 per cent in 1987 and has trended downwards all the way to the current level of less than 3 per cent. European and UK bond yields have followed a similar trajectory over the 30-year period, with a number of corrections on the way. Prior to the global financial crisis (GFC) – in the period between 2000 and 2007 – yields were around 5 per cent and were in fact considered low for the time. The current yields are therefore nothing new.
Focusing in on the past decade, yields have continued this downwards trend. The driver of this trend can be explained in two words: central banks. The US Federal Reserve was the first to react to the GFC by launching a QE programme in 2008, and the Bank of Japan and the European Central Bank launched their own versions of QE in 2014 and 2015 respectively. The impact of this was a sharp drop in global bond yields.
As the Fed was so much further along in the cycle than other global central banks, it was ready for the first interest rate hike since the GFC in December 2015. Despite the Fed having raised rates five times in a cycle, yields remained anchored. This is because of the effect of 'exported QE', which we will explore later.
Should investors be worried?
We have seen a swift rise in the 10-year US bond yield, which is now approaching 3 per cent. At the same time, there has also been an increase in volatility, with the CBOE Volatility Index reaching a multi-year high of 50. Consequently, many industry commentators are now talking of the start of a bear market in bonds.
Key Points
Investors have been concerned that the bull market in bonds is coming to an end
Central banks are reducing their support of the markets with QE
Interest rates are rising but they are not expected to rise substantially
The environment is changing, but it is important to bear in mind that this is a process of normalisation – central banks are withdrawing the extraordinary emergency measures they employed to offset the effects of the GFC. They are now acting from what they feel is a position of strength, the emergency measures having succeeded in meeting their aims with global growth improving.
What should investors bear in mind?
Firstly, it is difficult to anticipate how the market will respond. Similar headlines about the US 10-year bond hitting a 3 per cent yield proliferated at the beginning of 2017. However, last year, global fixed income enjoyed its best year in a decade, with the Bloomberg Barclays Global Aggregate Bond Index returning 7.4 per cent in US dollar terms (2.04 per cent in sterling) to investors.
Secondly, there are mitigating factors investors should pay attention to. Central banks are beginning to reduce their support of the markets, but will continue to be supportive overall, and any reduction in stimulus will be gradual. QE is also still being added in the euro area and in Japan, albeit at a slower pace.
The stock of bonds on central bank balance sheets still remains high (around €12.7trn – or £14.5trn – as of the beginning of January 2018) and this will act to weigh on yields far into the future. The rate of change is declining, but is unlikely to turn negative at least until 2019.
The effect of 'exported QE'
'Exported QE' is when money flows to the markets that have more attractive returns. This has the effect of keeping yields lower than would be justified by the central bank policy in that market.
Consider an investor in Japan who is getting increasingly negative returns on their assets due to the QE effect there. If they are able to buy US Treasuries at above 2 per cent, that is a much better investment. We saw this in 2016 and 2017, when Japanese investors invested €87.6bn (£76.4bn) in US sovereign bonds. This effect could be seen in suppressed US bond yields during 2016 and 2017 despite the less accommodative monetary policy in the US.
Interest rates are rising but we do not believe they are headed back to where they were three decades ago, as we are in a new environment of lower real equilibrium rates and lower global returns than in previous cycles. Similarly, we do not expect inflation to rise quickly or to levels we have seen in the past, meaning we are unlikely to see a corresponding sharp rise in yields.
Investors may read the headlines and worry, but they should bear in mind that we have been here before. Timing the market consistently is extremely difficult. A better approach may be a globally diversified portfolio that, along with equities, has an allocation to both government and corporate bonds – two sub-asset classes that do not always move together, meaning there can be a diversification benefit.
Investors should also remember the vital risk-dampening role bonds play in a diversified portfolio: fixed income tends to have a drawdown that is much lower than equities and can therefore be a safer long-term investment.
Christie Goncalves is a government bond trader at Vanguard Europe
