The bond bear growls
Epitaphs are being written daily about the death of the 35-year old bond bull market.
Could the long-feared bear market be upon us given the rapid ascent of yields?
Led by the US and Europe, 10-year yields are higher by 67 and 36 basis points (bp), respectively, over the last five months.
There are few more emotional terms than “bear market”; but it is important to define what this term really means.
Investors should be less concerned about terminology and more about what a rising yield environment might look like, how it might impact returns and what investment strategies stand the best chance of succeeding in this environment.
In fact, the range of potential interest rate outcomes is more manageable than many fear.
Interest rates bottomed in mid-2016
We have already been in a bear market (of sorts) for the last 18 months.
Developed market government bond yields troughed in the summer of 2016. You would be forgiven for not appreciating the significance of this.
Total returns from government bonds were positive in both 2016 and 2017 (see figure one); hardly the definition of a classic bear market!
Results were even better if one owned corporate or emerging market bonds.
And for those that navigated the volatile, uneven rise in rates, it was even possible to produce some very robust investment returns.
The secular arguments for low interest rates have been well documented.
Globalisation, ageing demographics, faltering productivity and the mammoth debt overhang have relentlessly pushed the equilibrium level of rates lower. These forces have been persistent for decades and are not about to vanish.
Sustainable, rapid growth will require stronger credit creation. Yet, the build-up in debt, both pre and post-crisis, makes this route unlikely.
The inflection point in yields was a reminder of the difference between yields staying low, as opposed to the argument that yields should not rise.
Secular forces (generating low inflation) will continue to supress yields. Cyclical forces, coupled with extremely low starting valuations, are pushing yields higher today.
However, we have likely reached the point where this tug of war moves to a new phase — tighter monetary policy is coming, although much is priced in, and inflation expectations have also moved higher.
Bear market or not, yields are unlikely to shoot sharply higher from today’s levels.
Cyclical forces are likely to push rates higher, but powerful structural factors will act as an upper bound and preclude a return to pre-crisis levels. Equilibrium 10-year yields are not far north of three per cent but a more convincing pick-up in wage inflation or credit creation is needed to move to a 3.5 per cent level.
And a move to 3.5 – four per cent at this late stage in the cycle would require strong global economic acceleration and a regime shift in fiscal policies.
You can call it whatever you want, but these outcomes do not spell impending doom. A bond bear market is not the equal of an equity bear market.
A central bank double whammy
Global bonds are contending with the headwind of rising policy rates and the decline of central bank asset purchases.
The removal of accommodation has left many wondering who the next marginal buyer of bonds might be.
But there are limits to policy. The European Central Bank for example, cannot tighten too much before the soaring euro crimps export growth. A policy mistake may also jeopardise equity market stability, the most important component of financial conditions.
Moreover, central banks will be data dependent. Figure three shows that the most important data — core inflation — is mostly missing in action.
Diversity — the beauty of global fixed interest markets
A rising rate environment does not affect all bonds equally and may not imply negative total returns for many bonds.
Credit and emerging market debt may perform better or worse than government bonds. Other assets such as floating rate notes and inflation-linked bonds can help protect from rising inflation.
And finally, higher rates are improving the ability of bonds to provide diversification in a broader portfolio via better performance in “risk-off” events.
The current cycle is getting old. There is a need for many investors to de-risk and fixed interest should play a vital role.
The challenge is to recognise that many of the investment rules have changed.
Growth at full employment is not generating inflation. Higher corporate leverage is not generating defaults and wider credit spreads. Central bank behaviour continues to distort markets. Benchmark-agnostic approaches that seek to solve today’s problems might stress interest, attractive returns with downside protection or low exposure to rising interest rates.
It may not matter whether this is a mere correction or a bear market.
Returns will of course differ, but the right approach for investors should be similar for both. If we are witnessing a more sustainable inflation upturn, it implies policy normalisation and a new rate environment, which requires a flexible approach.
Alternatively, we may be nearing the top of the range for rates, with inflation once again failing to accelerate. But again, this outcome demands a flexible approach.
Bond markets are not cheap and credit spreads are tight.
The challenge is to look beyond the mainstream for opportunities, adapt to changing rules and rotate across a wide range of investment opportunities.
In my view, flexibility is a prerequisite to success in today’s markets.
James Cielinski is global head of fixed income at Janus Henderson.
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