Yield not equal to return
Bonds have sold off a bit this week, but I believe that the bull market remains in place. Global monetary policy is about to be eased yet there are reasons to be relatively relaxed about the near-term growth outlook. The mini-bond sell-off will make yields a bit more attractive. However, yield does not equate to return unless you hold bonds to maturity and there remains scope for returns to be substantially higher than current yields, especially at the long-end of the maturity spectrum
Here we go again. Central bankers make dovish comments and stock markets print at new highs. The S&P500 broke through the 3,000 index level and the Dow Jones Industrial Average closed above 27,000 for the first time on the 11th July. These moves came after the US Federal Reserve (Fed) Chairman, Jay Powell, all but confirmed that rates would be cut at the Federal Open Market Committee (FOMC) meeting on 31st July. On this side of the Atlantic, central bankers have been sounding dovish as well. Executive Board member Coeure said that the European Central Bank (ECB) could re-start quantitative easing and that accommodative monetary policy was needed more than ever, given the renewed decline in inflationary expectations. Chief economist Philip Lane added that the bank has the tools to tackle any new economic downturn if necessary. Bank of England governor Mark Carney weighed in recently with a reminder to markets that the UK central bank also has the scope to cut rates should some of the risks to the global economy materialise. The Reserve Bank of Australia cut rates by 25bps at the beginning of the month. With inflation low, there is little risk from easing monetary policy further. Globally that adds up to some substantive support from central banks for the world economy and for risky assets.
One would be forgiven for asking whether easier monetary policy was needed. The US economy generated 224,000 new jobs in June, taking the total for the year to just over one million. The total number of people in non-farm jobs was 1.5% higher than a year earlier, a growth rate that has come down only very marginally in recent months. Of course, employment growth is not the only gauge of economic well-being. Recession probability indicators from two of the regional Federal Reserve banks’ research teams show that the risk of a recession in the next year is at its highest level since just before the last recession in 2009. The Atlanta Fed’s GDP “nowcast” indicator is also running at a rate suggesting sub-trend growth in the US, picking up on some of the trade-related weakness in manufacturing and business investment. In short, the data is mixed. Globally it has softened with the slowdown in China impacting on Europe. With risks around trade policy still present, it makes sense for central bankers to offer some insurance. The combination of the data not being so bad and central banks providing more accommodation is a heady one for equity markets and, by extension, credit. Returns so far this year reflect that.
Yield is one thing, return another
Faced with lower for longer rates, what should investors in fixed income be thinking? For my part, the bar-bell of short duration high yield (developed and emerging markets) and longer duration high quality government bonds remains an attractive approach. Yet I do sense that many investors need to be convinced to invest in long maturity government bonds because yields are so low. One principle I keep coming back to is the following; in actively managed fixed income portfolios where the active investment period is considerably shorter than one that would apply to a buy-to-hold strategy, the level of current yield is not necessarily the level of future returns. To illustrate this point, consider the last 10 years. The yield on the International Currency Exchange (ICE)/Bank of America-Merrill Lynch Global Broad Market Index, has been in a range of 1.0% to 3.14%. Yet total returns over 1-year holding periods have ranged from -2% to 8%. The current yield is just under 1.5%. Over the last ten years when the yield on the index has been within plus or minus 20bps of that level (1.3% to 1.7%) the subsequent one-year return has ranged from -1% to 7%. Another example is the long-end of the German government bond market. The yield on the over 10-year index was 0.64% at the end of 2018. To date, the total return of that index this year has been 10.6%.
What is at work here are the risk factors of duration and convexity. As yields have trended lower and bonds have been issued with lower coupons, average duration has tended to increase. The duration of the over 10-year US Treasury index has risen from 11.7 years a decade ago to 17 years today, in line with the decline in the average coupon from 6.4% in 2009 to 3.5% today. The higher the duration, the greater the price sensitivity of bonds to changes in yield. This sensitivity itself also changes in response to lower yields – a relationship known as convexity. Without getting too technical, the longer the duration and higher the convexity, the greater will be the price movement of a bond to any shift in yields. The current 30-year Japanese government bond, which matures in June 2049, has a duration of 28.2 years and a convexity of 8.4. The 30-year US Treasury, which matures just a month earlier in 2049, has a duration of 20.4 years and a convexity of 5.24. So, if you thought bond yields were going to move down in the next couple of months by, say, 10bps globally, you would be better buying the JGB than the US Treasury even though the latter yields more than 200bps more.
Of course holding long maturity bonds until they mature is a different story. Yields are very low and the phrase “that doesn’t make sense” is one that strikes a chord. A yield on 0.35% for 30-year Japanese debt, or 0.99% for French debt or 1.48% for Spanish debt does seem somewhat crazy. But having an active approach to managing fixed income means that advantage can be taken of the volatility that comes with higher duration assets, even if yields don’t move that much. This is important also in building multi-asset portfolios. The correlation between a long maturity global government bond portfolio (in either USD or EUR) has had a zero to negative correlation with equity indices over the last decade. As equity prices go down, so do bond yields which means the prices of longer dated bonds rise, helping to offset losses from equities. A bit of back of the envelope back-testing resulted in a composite 10% return over the last 5 years from a 60% US Treasury/40% S&P500 portfolio, with a volatility of just 6.5. The same analysis done for a Euro portfolio had a 6.1% return, though the allocation to bonds needed to be higher given the poor performance of European equities in recent years. In both cases having long duration exposure resulted in significantly better risk-adjusted returns than a pure equity portfolio.
We are in the 5th bond (price) bull market of the last decade. The previous peaks have been September 2010, June 2012, March 2015, and July 2016. This current bond rally started in October of last year for Treasuries and February of last year for Bunds. It may have further to go if central banks are going to ease again. Compared to the previous peaks, the price of Treasuries has more room to increase relative to that of bunds, reflecting that US yields are still quite high. A yield target of 1.0% - 1.5% for the US 10-year to 30-year sector does not seem that outrageous if the Fed is set to ease significantly over the next two years. That means price returns in double digits still from here at the long end of the Treasury curve. The bond bull market isn’t necessarily over.
There’s a lot more cricket to play before the football season starts. The Cricket World Cup has been great to watch, and now England are in the final it’s a rather exciting climax. Sunday looks to be warm but cloudy, so there should be some movement in the Lord’s pitch. Our bowlers have proved to be quite devastating when on form, so hopefully more of the same against New Zealand. A win would set up England very nicely for the Ashes. And before you know it I will be boring you all again about Manchester United’s trials and tribulations. Until then, it’s all leather on willow.
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