Fixed income markets often look more complex than they need to be. Jargon-heavy terms like “duration”, “roll migration” and other curly names are undoubtedly important, but are very often secondary to simple fundamentals such as the starting yield.
The Easy Big: Knowing the Starting Yield
The starting yield has been an incredibly powerful determinant of future returns among government bonds. This is in part due to the fact that default risk is considered to be very low and thus the contributors to risk and return become simplified.
The below chart depicts the relationship between the starting yield and future returns from 1957 to today, including over 4,000 validation periods. It includes a diverse range of countries comprising the U.S., U.K., Germany, Canada, Australia, Belgium and South Africa, which is a meaningful collection of data that removes country-specific idiosyncrasies and demonstrates the benefits of a buy and hold approach in fixed income when the starting yield is high.
The Hard Bit: Understanding the Change in Yields
As can be seen above, the starting yield is said to explain as much as 85% of the variability in government bond returns. This is monumental, with the strong relationship applying across every tested market regardless of country-specific risks such as debt levels, fiscal stimulus, monetary stimulus inflation rates; and so on.
The compelling nature implies that investors would be better placed devoting their attention to the starting yield rather than speculating about the next move by the central banks. It is both knowable and important whereas central bank moves are largely unknowable and less important. To provide evidence of this, we can see below that the change in yield impacts returns, but has a significantly weaker relationship than the starting yield.
Bringing this to Today’s Super Cycle
With overwhelming historical support showing the power of the starting yield relative to the change in interest rates, it is baffling that so many investors speculate over the next decision by the central banks. To our eye, an investor would be much better placed by retaining perspective, understanding that the low interest rate environment is highly likely to reduce the future return expectation for investors in fixed income. The below chart provides a stark outlook in this regard, with current bond yields at dangerously low levels.
One cannot remove themselves from the challenges outlined above, but we can deal with them in a rational manner. In doing so, it is worthwhile outlining that there are at least four important points to note when considering fixed income exposure at a portfolio level.
Inflation targeting is only 20-30 years old – it was only in 1992/93 that the world really started to move towards inflation targeting. New Zealand was said to be the first of the modern era to begin inflation targeting back in 1989, after which a raft of other countries followed suit in the ensuing 5 years. Therefore, it is worth challenging the above analysis by considering the inflationary impact in a modern context. We do this by breaking down the contributors of returns, acknowledging the role inflation targeting has on prospective yields.
The starting yield may lose some of its power at very low rates – if we consider bonds on the basis of variability, we find that when yields have historically been under 5% the starting yield only explains an insignificant 2.9% of the variability of returns. Therefore, while the absolute return is impacted by the starting yield, future volatility may be more likely to be sourced from the change in yield over time rather than the absolute level of yields. In fact, the change in yield is said to be twice as important to variability when rates are under 5% than when rates are high. While this is mathematically intuitive, it is important in the context of risk.
The negative correlation to equities creates a dilemma – while there is compelling evidence to suggest fixed income returns will be low for a fixed income investor, we must also consider the total portfolio impact. In this regard, one must acknowledge the perceived diversification benefits that can be sourced from having negatively correlated assets. This poses a significant challenge to a long-term investor, as the avoidance of fixed income from a portfolio may increase the volatility of returns, even though it is the right decision from the perspective of the long-term return.
Therefore, while it seems an oxymoron to invest in something because it helps offset volatility, despite the expectation it will deliver a negative real return, the reality is that many investors continue to be comforted by the smoothing effect it provides and may thus be more likely to stay invested.
An ageing population and pension funding could support demand – the demographic challenges are well known, and retirees continue to use fixed income as a means of delivering less volatile outcomes. Therefore, if one considers government bonds purely on the basis of supply and demand, it may support the ‘lower for longer’ rhetoric that many claim.
The Lessons for You Portfolio
If an investor wants to maximise their long-term return, government bonds generally appear an exceptionally dangerous place to be. With starting yields at or near the lowest levels in recorded history, and a 60-year record providing compelling evidence supporting these dangers, government bonds could be in for a bitterly disappointing ride ahead.
This will shape portfolio construction in a myriad of ways and will play an important role in the success of multi-asset solutions for decades to come.
Valuation-implied Returns after Inflation
It is also important to note that the returns in the previous charts are in nominal terms, meaning they do not even account for any inflationary pressure. If we include inflation, allowing for a real relative comparison, we quickly find a situation where the prospective returns could easily be negative over the coming 10 years. This is evident in our valuation-implied returns below.
