Time to take the long view when it comes to bonds

A sell-off in global stocks on Friday 9 September – the most violent move in either direction for a good couple of months – was swiftly put down to a sell-off in global bonds. That fixed-income frenzy was in turn attributed to hawkish comments from a pair of US Federal Reserve officials, Eric Rosengren of Boston and Federal Reserve Board member Daniel Tarullo, who hinted that the US central bank could discuss interest rate rises in the near future.

Japanese and German bonds had already begun to sell off, inflicting potentially nasty capital losses on anyone who bought near the summer lows in yield and highs in price.

As these charts show, tiny movements in yield have prompted big movements in price (remember that bond prices move inversely to yield, just the same as share prices – the higher the price, the lower the yield and vice-versa).

The challenge for bond investors is that yields are so skinny on the 10-year German Bunds and Japanese Government Bonds (JGBs) – the yields are in fact negative, albeit now only just in the case of Bunds:

Sell-off in German Government Bunds has created a fresh bout of global market nerves

Source: Thomson Reuters Datastream.

... especially as Japanese Government Bonds (JGBs) have wilted in price too

Source: Thomson Reuters Datastream.

Such market action only deepens the quandary in which the US Federal Reserve finds itself.

Prior rhetoric from chair Janet Yellen, her deputy Stanley Fischer and several other members of the Federal Open Markets Committee’s members, notably John Williams of the San Francisco Fed, had already suggested the American central bank was itching to raise interest rates.

Yet when it has come to the first five of the FOMC’s eight meetings in 2016, the central bank elected to do nothing, even after talking a good game. This seems to be because the US economic outlook remains mixed at best and in many cases the data do not justify increased borrowing costs, or suggest US firms and consumers could withstand them too easily.

A fresh market tantrum could further box in Yellen and her team, who (rightly or wrongly) continue to place huge emphasis on rising asset prices as a source of potential wealth creation and thus a stimulus to corporate investment and consumer spending.

Equity markets have thus far in 2016 been much more sensitive to talk of rate hikes than bonds, but last Friday’s action suggests even fixed-income investors are now getting windy.

Yet the case for a rate rise still seems relatively weak – even if it would be lovely to think the economy was strong enough to begin the long process of normalising the cost of money.

As a result, this could be no more than just the latest in a series of flaps in the fixed-income world which have ultimately been followed by fresh downward moves in yields as advisers and clients decided that neither rate rises nor higher inflation were coming quickly.

It is understandable that many are nervous, with yields so thin, but it remains to be seen whether now is finally the time to slash back the bond component of a well-balanced portfolio or whether this latest tantrum is just another chance to buy more long-dated Government paper and snap up what little yield is left on sovereign debt.

Grinding lower

The US 10- and 30-year Treasury bond yields have ground remorselessly lower, providing advisers and clients with welcome capital gains (at least on paper) to supplement the regular income they provide in the form of coupons.

Latest fixed-income flap in US comes after long grind lower in 10- and 30-year Treasury yields

Source: Thomson Reuters Datastream

The same pattern has been clearly discernible in Germany, Japan and also the UK – the next chart looks at the trend on this side of the Atlantic over the past 12 months:

The UK has seen the same pattern as the US Government Bond market

Source: Thomson Reuters Datastream

Whether this latest wobble in Government bonds is the result of fears that interest rates have been too low for too long (with the result that inflation will soon outstrip meagre bond yields), or a reflection of the view central banks are primed to swiftly increase headline borrowing costs is open to debate.

At least it is relatively easy to track market thinking on both issues.

In the case of inflation, the St. Louis Federal Reserve database, FRED, provides free data on five-year forward inflation expectations in the US. There has been a small increase here, but nothing of great note – as yet:

US inflation expectations remain subdued

Source: St. Louis Federal Reserve database, FRED

In the case of US interest rates, it is possible to gauge what the market is pricing in by way of Fed activity by looking at the CME Fedwatch tool. By looking at Fed funds futures prices, it summarises the market’s views on the likelihood of changes to headline interest rates in the form of a percentage.

The chart below covers the next eight scheduled FOMC meetings. September shows an 85% chance of no change and just a 15% chance (in the market’s view) of a 0.25% rate hike from chair Yellen. It is only by June 2017 that the odds on a rate hike outweigh those of no change.

Futures markets suggest the Fed may not hike rate until summer 2017

Source: CME FedWatch, as of 13 September 2016

If this is correct, then the 1.53% yield available on the US 10-year and 2.22% on the 30-year may still tempt income-hunters – especially as these figures easily outstrip what is available from other leading developed sovereign bond markets and the buyer gets access to the world’s reserve currency, the dollar, at the same time.

The table below is the latest update of a graphic that regular readers will have seen before.

Many developed Government bond yields remain in negative territory

Source: Thomson Reuters Datastream, as of 12 September 2016

Macro concerns

Yet for all of the confusion sown by the US Federal Reserve, it is relatively easy to understand why it remains nervous of raising interest rates, even if it would like to begin the process of normalising monetary policy after eight years of record-low borrowing costs and trillions of dollars in Quantitative Easing.

First, headline GDP growth remains ordinary at best – barely 1% annualised in the first half of 2016, a rate unlikely to stir the trigger finger of any FOMC member.

US GDP growth remains relatively feeble

Source: St. Louis Federal Reserve Database (FRED)

Second, America is awash with debt.

  • The government deficit stands near $16 trillion and is moving above the 80%-to-GDP threshold which Kenneth Rogoff and Carmen Reinhart identified in their book This Time It’s Different as the level where debt can start to weigh on an economy and crimp growth.
  • Data from the St. Louis Federal Reserve shows that the amount of outstanding commercial and industrial loans in America has all-but-doubled to $2.1 trillion since 2007.
  • Figures from the New York Federal Reserve show that total US household debt is more than $11.5 trillion ($8.4 trillion in mortgages, $1.3 trillion in student loans, $1.1 trillion in auto loans and $700 billion on credit cards) – equivalent to more than $250,000 per household. Any gallop higher in interest rates would smother consumer spending and puncture what little growth the US is generating.

Third, there is one area where the US is showing considerable growth – and that is corporate bankruptcies. August’s figures from the American Bankruptcy Institute show a 29% year-on-year increase, the tenth consecutive month of higher failures according to www.wolfstreet.com – and that at a time when bond yields are plunging and interest rates anchored near zero.

Looking at this another way, the delinquency rate on US commercial and industrial loans is still just 1.6%, but it has doubled from its late 2014 low of 0.72%, and that at a time when bond yields are plunging, interest rates anchored near zero and the US economy allegedly doing well.

US corporate loan delinquency rate is rising sharply (albeit from a very low base)

Source: St. Louis Federal Reserve Database (FRED)

Portfolio sensitivity

If interest rates (or inflation) do rocket then it will be easy to look back and with hindsight argue that bonds at this stage of a 35-year bull run offered nothing more than return-free risk.

But if interest rates remain lower for longer (or even go lower still, a prospect few if any are really entertaining at the moment) then the few Government bonds which still offer a positive yield may have their uses in a well-balanced asset allocation, especially those tradeable Government debts that offer a positive yield and come in dollars.

Granted, long-dated paper comes with greater price volatility but seeking out flexible allocation bond funds with an exposure to long-dated US Government debt is one option to consider for patient, income-hungry clients.

The knowledge there could be a few lumps and bumps along the way means a fund may be a safer option that a substantial position in long-dated Treasuries or Gilts only as the diversification would be a useful protection against any sudden shift in Fed or Bank of England Policy or the market’s inflation expectations.

The table below lists the five best-performing flexible global bond funds over the last five years.

Best-performing flexible bonds funds over the last five years

Source: Trustnet, Morningstar, for GBP Strategic Bond category
Where more than one class of fund features only the best performer is listed.

It may be then worth analysing these collectives for their asset allocations by asset class (Government, investment grade or high yield), geographic mix and where possible maturity profile, in the knowledge the shorter the duration of a fund’s holdings the better protected it is against interest rate rises, and the longer the duration the better performance will be if interest rates do not go up.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.