In this blog post I will do my best not to sound like a broken record but I may not be able to avoid saying “I told you so”…
For some time now we’ve been banging on about the lack of value in government bonds.
Less than two months ago the yield on the UK 10 year gilt was around 1.5% pa. That’s what you get paid if you lend money to the UK government for a whole decade. It’s not a great deal and in our view should be higher.
Even worse was the 10 year German government bond (known as a “bund”). Two months ago the yield on the 10 year bund was basically zero (actually it was 0.05%pa). That was just crazy and we felt that yield had to go up substantially.
In the bond markets, when yields go up that means capital values are falling. As a result, we’ve been bearish on government bonds and fixed interest in general for some time.
The other thing we’ve been harping on about was high correlations between the equity markets and the bond market. Normally, these are relatively uncorrelated and often move in opposite directions. We’ve noted that this has changed recently and they are increasingly moving in the same direction, which means we thought that if the bond sell-off came to pass it would also knock the equity market.
From Nought to 100
Now for the “I told you so” bit…
This week, bonds have been selling off fast, nowhere more so than in Germany. Earlier today (4 June) the 10 year bund yield hit circa 1% pa. That’s still not very much but it’s a HUGE move from zero two months ago.
The UK 10 year bond is now up to around 2.2% pa, not quite such a dramatic change but a long way from 1.5% pa.
And of course the equity market has not proved immune, with the FTSE 100 down 1.5% at one point today and the FTSE Eurofirst 300 down 1.3%. Told you so.
Ok I’m going to stop being facetious now and tell you what I think’s going on.
Firstly, we are not the only people to have noted the terrible value in bonds. Prices have been driven up by quantitative easing (QE) where a central bank buys bonds with newly “printed” money. Those investors who have sold bonds to the central bank have often put the money in equities. Therefore, QE drives up equity prices too. Sorry, I went a bit “broken record” again then.
However, you can argue that low bond yields are rational when you have low economic growth, low inflation and negative interest rates (as you have in Europe). In one sense, a 10 year bond simply reflects expectations of interest rates over the next decades, with a premium for default risk depending on the bond issuers. With the UK or Germany the default risk is as near to zero as you can get.
When bund yields were zero they were reflecting zero interest rates for a decade. That was either wrong or something was not right in Europe. There is no doubt that Europe was struggling at least until recently, with low growth and even lower inflation. In fact, we have seen pockets of deflation. Low yields are therefore justified, just not that low.
However, European economic growth has picked up and even inflation is rebounding. This “good news” was one of the main causes of the bond sell off in my view, with a knock on to stockmarkets.
QE creates lots of paradoxes. Good news is often seen as bad news for markets. In addition, whilst QE works by driving down bond yields, if it does work and creates growth and inflation, yields need to go up again. QE therefore should make yields go both down and up. At the same time. Hence, we see a lot of volatility.
So far I’ve not really said anything we’ve not said before. However, here’s the twist.
After the selloff, some bonds don’t look bad value. Longer dated bonds still look very poor value in my opinion, but at the shorter end of the curve things are different.
A five year gilt now yields close to 1.6% pa. That might not sound great but remember it basically reflects interest rates over the next five years. Base rate is still 0.5% pa and consensus is that it might remain there well into 2016.
Bank of England governor Mark Carney has also said that when rates go up they will do so gradually and will settle substantially below where they were pre-financial crisis. We think this may be 2.5% maximum, half of the 5% level they were before the credit crunch.
Let’s do some back of the envelope calculations. Say rates remain at 0.5% for 12 months and in the following 12 months they average 1%. They average 1.5% during year three and 2.5% for two years after that. The average rate over those fives is about 1.6%, the same as a current five year gilt:
This is a crude way of looking at it, but if rates follow a similar pattern to my table, which many people think they will, the current five year rate is pretty much spot on.
I happen to think rates might get to 2.5% quicker than that, and perhaps 2% pa feels a more reasonable level for a five year bond. Whatever the “right” level, after the recent sell off the shorter dated bonds certainly look much more realistic. However, we’d still be wary of long dated bonds even if we had someone else’s bargepole.
Of course even 2% pa over five years would not be much to write home about, but we are talking about a so-called “risk free” bond. Higher yielding corporate bonds would earn a premium above that level, depending on the credit rating of the company.
A settled, realistic yield on government bonds make such assets (and property and stocks to a lesser extent) much easier to assess and generally more attractive.
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This publication is for information purposes only and does not constitute advice, please consult your financial adviser. Investments can fall as well as rise. Past performance is not necessarily a guide to future.