World bond yields have risen in recent weeks as central banks look to raise interest rates or reduce quantitative easing programmes. Plans for tax reform in the US could mean faster growth and a larger fiscal deficit, which will push up bond yields.
In early September bond yields had fallen to a cyclical low as investors, worried about a potential clash with North Korea, had sought the safety of government bonds, sending prices up and yields down. More recently, however, the degree of concern over geopolitical risk has reduced, and, in addition to less safe-haven buying, a variety of other factors have also nudged yields back up again.
In the US, UK, and eurozone, previously very accommodative monetary policy is beginning to turn towards a modestly less supportive setting, again pointing towards interest rates starting to move back from their historically low levels.
In the US, for example, the benchmark 10-year Treasury yield, which had hit a North Korea-affected low of 2.04% on September 7, is now back up to 2.32%. There have been similar increases in the equivalent yields in the UK – 0.97% on September 7 to 1.28% now – and the eurozone, which has risen from 0.30% to 0.40% in the same period. Japan is the major exception, where the central bank looks likely to stay with its very easy monetary policy, and the 10-year government bond yield, though up by a tiny amount since early September, remains close to zero.
Recent rises in yields have detracted from returns, because of the associated capital losses. For the year to date, however, yields have not risen far from where they were at the start of the year, so the capital impact thus far has been relatively minor and partly offset by falls in credit spreads on corporate debt. For the year to date, the Bloomberg Barclays Global Aggregate Bond Index has returned 5.9% in US dollar terms, with global government bonds returning 5.7%, global corporate bonds 7.6%, emerging market debt 7.9%, and global high yield 10.0%.
Monetary Tightening Ahead
In the US, UK, and eurozone, though not Japan, monetary policy is likely to be slowly and carefully normalised after an extended period of exceptionally low interest rates, which will make life difficult for bond investors.
In the US, for example, analysts are expecting another rate rise by the Federal Reserve by the end of the year, with December pegged as the most likely month. Whoever succeeds Janet Yellen as the head of the Federal Reserve may go for a brisker pace of monetary tightening than Yellen and her colleagues.
The story is the same in the UK. The most recent Bloomberg survey of UK economists in October, for example, found that three fourths of them think there will be a 0.25% increase in the UK policy rate at the Bank of England’s next policy meeting on November 2, but that rates will then stay on hold all the way out to 2019, when they expect two more 0.25% increases.
In the eurozone, outright interest-rate increases still look to be some considerable time away –possibly not until 2019 – but the European Central Bank’s policy meeting on October 26 halved the amount of bonds it has been buying to €30 billion a month. Among major markets, only in Japan is monetary policy expected to remain at its current full-on supportive setting.
High-Yield Bonds a Crowded Trade
This all makes for an uncomfortable outlook for bonds, and it is not surprising that in the latest Bank of America Merrill Lynch (BAML) survey of fund managers in October, 85% thought bonds were overvalued, 82% expected yields to rise during the next year, and a net 61% are underweight in bonds. It was also not surprising that the risk fund managers were most worried about was a policy mistake by the Fed or the ECB as they set out on the difficult exercise of unwinding their post-crisis programmes of monetary stimulus.
The fund managers were also concerned about the previous rush into outstanding niches of yield in a low-interest-rate world. The BAML survey asks them what they think are the “most crowded trades”. The single most crowded trade was technology shares, but the second was US and eurozone corporate bonds, where credit premiums have been driven down to unsupportable levels.
At the start of this year, for example, the yield on eurozone high-yield debt was 3.33%, when the yield on the 10-year German government bond was 0.17%: investors were being paid a credit premium of 3.16% a year to hold low rather than high quality. Currently the low-quality yield has dropped to 2.17% while the high-quality yield has risen to 0.46%, meaning that the credit premium has almost halved, to 1.71%.
Investors are currently not paying a great deal of mind to potential risks, economic or geopolitical, and there is a case to be made that holding an appropriate allocation of bonds still acts as a useful insurance policy against risks that others appear to be underestimating. But that is as far as the good news extends: the economic fundamentals are currently lined up against bonds, in particular against niches, such as lower-quality corporate bonds, where value is most stretched.
