Many investors were surprised to see the bottom-line of their portfolio fall through November in the aftermath of the U.S. presidential election, despite seeing news headlines of record highs in equity markets. This is especially true for “lower risk” portfolios that have a high allocation to bonds.
In many respects, we saw evidence of the short-termism that grips investors from time to time. A portfolio that is traditionally structured with 20% in equities and 80% in fixed income will naturally find it hard when bond prices fall, even if bonds/equities tend to move in opposite directions. For those that were more cautiously positioned - including Morningstar Managed Portfolios with a high cash allocation and an aversion to over-priced bonds - performance can slip when almost all boats fall on a receding tide.
These sudden shifts are inevitable from time to time, although one can never be sure what the catalyst nor sustenance will be. While we cannot draw strong inferences from this price volatility, it does provide a timely reminder that bond markets may not be sexy but they are indisputably important.
Could We be in the Midst of a Bond Market Crash?
There is a lot of talk about bond bubbles and what the fair value of a bond should be. Without getting caught in the hype, it requires us to think about the total expected return of a bond. This simplistically comprises income, via coupon payments, and the potential for a capital gain or loss.
The beauty of bonds is that we know the starting yield. Therefore, in the absence of default by the bond issuer, we know the return over the lifetime of the individual bonds. However, we do not know what the real – after inflation – return will be and it is considerably more difficult to estimate the return of bond funds as changes to the underlying portfolio affect the future expected return.
In order to have a full appreciation of the expected return of a bond investment, we must therefore have an appreciation of the ‘fair yield’ of the bond together with an estimate of future inflation and the impact of default risk.
Government Debt: It Still Doesn’t Stack Up
In this context, it is natural to ask at what level can we reasonably expect yields to normalise and how quickly could it happen? For example, if one could reasonably expect yields to spike to 6% by the end of 2017, the risk of a crash is significant. However, such short-term predictions are seldom useful and therefore only suitable as a maxim. ‘Know what you don’t know’ serves investors well in this regard.
No-one knows the timing of a bond yield spike, nor how high it will go. The only thing one can do is to consider long-term yields using fundamental building blocks as opposed to forecasting or moving averages.
Forecasting is fraught with danger. Making economic predications about the varied success of Donald Trump’s proposed fiscal expansion, then extrapolating how that relates to the ageing population and other economic factors is not a reliable way to understand what that will mean for inflation, real rates, default risks, bond issuance and so on. There is simply too much scope for error.
Similarly, another misleading approach is the use of moving averages. The bond market dynamic has changed so significantly over time and it makes little sense that recent history will repeat itself in this regard. For example, in 1990, inflation was high, central bank balance sheets were small and debts were low – today the opposite is true.
The most intuitive approach is to therefore use fundamental building blocks. Specifically, one can build a more realistic assumption about where yields could go in the long-term by incorporating central bank inflation targets, a conservative assessment of real yields and evaluating the shape of the yield curve.
Using this approach also has the benefit of being one of the most conservative methods. While our assessment of long-term yields varies by country, they are still considerably higher than current levels. In the U.S. for example, our fundamental approach leads us to expect nominal long-term yields in the vicinity of 4-5% based on current structural considerations, compared to current levels of approximately 2.5%. By its very nature, this is not conducive to strong performance because prices will fall if yields revert to 4% or higher.
Corporate Debt: Losing Some of its Attraction
The extension is to consider higher risk debt. High yield has been an area of opportunity, as default risks were seemingly priced in beyond what a reasonable outcome depicted. For example, if we looked at high yield debt, late 2015 and early 2016 saw an abnormal spike in yields despite reasonably low default rates. Going forward, this default anomaly has dissipated somewhat. Consequently, we have been reducing our return expectations for this asset class.
