By Michael Mabbutt
In September 1981, yields on 10 year US Treasuries reached nearly 16% per annum. Today they are a little over 2% per annum. It seems reasonable to wonder if the end of the long bull market in bonds has finally arrived, especially with the US Fed apparently ready to raise short term rates this month. But this is a lazy idea, for two reasons.
First, there is a plausible scenario that drives US Treasury, and UK Gilt, yields closer to zero. After all, it has already happened in both Germany and Japan, where 10 year government bond yields are below 0.5% per annum. The scenario involves the inability of the US, and the UK, to escape an excessive reliance on debt and the effects of ageing populations. Continued sluggish economic growth has two implications; it keeps a lid on inflation and it makes economies more vulnerable to cyclical downturns and deflation. Such a world would allow Treasuries and Gilts to do quite well.
Second, even if it is the case that developed country government bond yields begin to rise (prices fall) meaningfully, there are other bond markets on the menu to consider. The global bond markets are substantially broader than just those represented by developed country governments. Corporate bond markets (both investment grade and high yield), whilst not very liquid, are now substantial in size. Even more substantial are the, more liquid, government bond markets of developing countries. Both of these markets have already adjusted, at least partially, to the threat of higher short term rates in the US.
The yields on US High Yield corporate bonds have risen from 6.5% per annum in May to 8.5% now, whilst those in Europe have risen from 4% to 5% per annum. These yields represent reasonable margins over their respective government bonds, as long as those government bond yields do not rise too quickly and too much.
But corporate bonds have characteristics that are meaningfully different from government bonds; the corporate bond markets are fragmented, with many issuers and relatively small issue sizes. The ability to transact in corporate bonds is challenging as they are not very liquid. This makes them better suited to long-term investors such as pension and sovereign wealth funds than to daily-priced retail funds where investors can be fickle and redemptions executed at short notice.
For those wanting government – rather than corporate – bond exposure, developing country bond markets should feature prominently on the global bond menu. These markets have adjusted aggressively to the possibility of rising rates in the US, having suffered since May 2013 when Ben Bernanke first mentioned a reduction in Fed tapering.
Emerging market US dollar denominated government bond yields have risen from 4.5% to over 6% per annum. Notably, prevailing yields are lower than on US High Yield corporate bonds but this is justified due to the latter’s lower average credit quality. But of all the world’s bond markets, local currency bonds have adjusted the most, dropping nearly 30% in total return terms since May 2013.
The bulk of this loss has been due to currency depreciation. Local bond yields have risen too, but the resulting capital losses have been largely offset by coupon receipts. Investors should not ignore these markets after such an adjustment. Most developing countries now have flexible exchange rates, after the failed fixed exchange rate regimes of the 1990s and early 2000s. This provides a necessary adjustment for imbalances, whether they be excessive cumulative capital inflows or large current account deficits.
Current account deficits, where they exist, are shrinking rapidly and investors will need to think of other reasons to stay bearish. Many currencies (apart from those in Asia) are now substantially weaker in real effective terms than just five years ago and this increased competitiveness will help to correct the imbalances that attract so much negative sentiment.
In addition, central banks in many developing countries have raised their reference rates several times since 2013 and are well into their tightening cycles – an encouragingly orthodox response to higher domestic inflation fuelled by weaker currencies. Longer dated bonds in these countries have also responded with higher yields, creating a potential opportunity for yield-seekers.
The idea that we have reached the end of the long bull market in bonds is lazy. It might not be true – witness the outcomes in Germany and Japan. And even if it is true, the idea describes only the world of Treasuries and other developed country government bonds. There are alternative bond markets that have already discounted (some partially, others more fully) a world of higher rates. Investors would be well advised to consider them.
Michael Mabbutt is head of global credit at Liontrust Asset Management
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