Central Bank speculation remains rife. Overvalued bond markets, following years of accommodative monetary policy, have seen heightened volatility of late as coordinated rhetoric from prominent central banks – especially in the US, UK Canada and Europe – signals that we are likely moving back to a more normal interest rate environment, albeit slowly. With this, the central bank support that has stimulated bond markets for many years is at risk and could have significant implications for fixed interest markets.
Apart from cash, government bonds are one of the only assets to offer capital protection
If interest rates rise bond prices fall, so the primary question that people want answered is the speed of any normalisation process as this will frame investor expectations on the bounds of potential scenarios
Interpreting Central Bank Speeches
With changes afoot, it begs the question of the role central banks play and the way they impact the fundamentals of investing. On this point, one must appreciate that central bank activity is already considered one of the most influential and heavily scrutinised inputs into investment calculations, making it very efficiently priced in and difficult for investors to obtain an edge.
Anyone trying to play the game of central bank front-running needs to have access to information that others don’t – which is practically impossible under legal bounds, a special ability to interpret what is going to be said – extremely difficult, or what has already been said – usually priced in.
The challenges of the first two points are obvious and failures are repeated again and again. This has come to the fore in recent times, with many in the investment community failing to foresee the swift change in tone from Mark Carney of the Bank of England, Mario Draghi of the European Central Bank and to a lesser extent from Janet Yellen of the Federal Reserve.
How to Figure out What This Means
Of course, there is valid reasoning behind the desire to watch the central banks. The timing and magnitude of any potential unwinding to the record stimulus could well set markets off; for example, the ‘taper tantrum’ of 2013 saw asset values materially shift. Too much, too soon could put excessive stress on consumers. Too little, too late and the so-called ‘bubble risk’ lingers.
Yet beyond the headlines, there are other important issues at play and these may prove equally influential in the long term. Under record-low rates, governments around the world have been incentivised to increase the duration of their debt parcels. And increase they have. While the average maturity of a bond was 7.9 years in 2007, the average maturity is now closer to 9.5 years for the global government bond index. This might not sound like a lot, but it increases the sensitivity to interest rates and could prove quite problematic if bond yields rise rapidly from their low base.
This will impact some fixed income markets more than others. Usually, the worst combination in a rapidly rising bond yield environment is a low starting yield and long duration. For this reason, we are seeing many fund managers carry ‘low duration’ positioning as a means of reducing such sensitivity or favouring higher yielding markets.
It is worth noting though that there are circumstances where a rapid rise at the front end of the curve can lead to a fall at the back end of the curve if investors deem higher policy rates will suppress inflation in the future.
Impact on Developed World Debt
Apart from cash, government bonds are still one of the only assets to offer consistent capital protection, and in some cases positive returns, when growth assets are significantly negative. While we avidly avoid the weaknesses inherent in trying to predict the unpredictable, one of the ways we can comprehend central bank moves is to put forward a variety of plausible scenarios. As an example, the below depicts four cases for the U.K. government debt market, which we can then use to understand reward for risk.
Starting with the positives, the German experience gives us an idea of the upside potential for government debt; even from current low yields, the Japanese experience was similar. In fact, a plausible ‘German style’ scenario would result in a circa 18% return if it transpired over one year.
However, the downside risk is high as well, and a similarly plausible scenario would see -19% return over one year if bond yield reverted to December 2013 levels of 3.5%. One can only imagine the losses if a sudden inflation spike saw bond yields jump back towards the pre-2008 crisis levels above 5%.
This could have a major impact on defensive investors. For lower risk portfolios, history shows that drawdowns have typically been a combination of very negative returns on growth assets with slightly negative returns on government debt. However, our scenario analysis shows that very negative returns from fixed income should not be dismissed.
What does this Mean?
Governments bonds are undoubtedly expensive, offering low valuation-implied return that potentially have significant downside risk. That said, they play a key role in the overall asset allocation – especially for lower risk portfolios.
