While the third quarter of 2017 saw global bonds return less than 1% - against a rise of over 4% for world equities - the period marked a key turning point in the direction of monetary policies that have underpinned extraordinary medium and long-term gains. The key date in this change was September 20, when the US Federal Reserve formally announced that it will begin to unwind its $4 trillion stimulus programme.
Other central banks followed the Federal Reserve’s lead: the European Central Bank, in its late October meeting, said that it would halve its monthly bond purchases from €60 billion to €30 billion from January next year. The Bank of England raised interest rates for the first time in 10 years on November 2. The Fed is expected to raise interest rates again at its December meeting.
These central bank moves occur at a time when valuations in developed-world-bond markets appear increasingly expensive, raising the risk of losses in these asset classes. Understandably against this backdrop, developed-world bonds struggled in the third quarter as yields pushed higher, with longer-dated securities particularly affected. Credit and the bonds of emerging-markets nations like Brazil continued to outperform.
Yields and credit spreads – the margin above government bonds that investors demand to invest in these relatively riskier securities – are now well below long-term average levels.
Government Bonds are Overvalued
While developed world bonds represent marginally better value than at this time last year, Morningstar analysts believe that government bonds in the UK, Europe, Japan, and, to a lesser extent, the US, are significantly overvalued.
In each case, investors are being forced to accept lower yields and longer duration - the time period before a bond repays capital invested – than what they have been faced with historically. With bond yields still low in a historical sense, this reduces current cash flows whilst also increasing the risk of capital loss should bond yields rise towards their longer-term fair value.
The risk of this happening is growing, in our view, as the seemingly coordinated actions of central banks that have for so long been a tailwind for bond investors could well turn into a substantial headwind. Accordingly, we maintain an underweighting in the asset class, believing that investors must adopt a preparedness to be different from the index in identifying opportunities that offer a superior reward for risk.
We have greater conviction in the investment case for emerging-markets bonds, particularly where those bonds are issued in the currency of the emerging-markets nation, although country and currency selection remain vital. With higher yields on offer and, in many cases, emerging-markets countries having much better debt positions, the reward for risk looks superior to that of most developed-markets countries. That said, our positive view has been tempered in recent months as strong returns from the asset class across 2017 and improving sentiment, as investors become more comfortable with the outlook for key emerging markets, sees the reward for risk fall.
