Note: This article was originally published on Oliver’s Insights on February 12 2015 and has been republished with permission from the original author.
When I started my career over thirty years ago, Australian ten year Government bonds offered a yield of around 14% and global bond yields were similarly high. The big question then was why they were so high? Now, it is why are they so low? The ten year bond yield in Australia is just 2.6%. In the US its 2%, Spain 1.6%, Germany and Japan just 0.4% and in Switzerland it’s actually -0.04%. (Yes in Switzerland you pay the Government to lend them money – as the Swiss central bank has set short term interest rates even more negative).
This is an important issue because if you buy these bonds and hold them to maturity those yields are the annual returns you will get! This note looks at why bond yields are so low, whether it’s ultimately sustainable and what it means for investors.
How bonds work
But first it’s worth a reminder as to how bonds provide returns. Like most investments, bonds have a price and a yield, but most commentary occurs in terms of the yield. If the government issues a bond for $100 and agrees to pay $4 a year in interest, this means an initial yield of 4%. Obviously the higher the yield the better in terms of return potential, but in the short term the value of the bond will move inversely to the yield. So if growth or inflation slows and interest rates fall investors might snap up bonds paying 4% till the yield is pushed down to say 3%. In the process the value of the bond goes up giving a capital gain for investors. This is what’s happened lately. But, if growth and inflation pick up and bond yields rise, investors suffer a capital loss. And if for the remainder of the life of the bond the yield remains 3% that will be the return, ie 3% pa.
Why are bond yields so low?
Ultimately it’s anyone’s guess as to the precise reason why bond yields are so low but it likely reflects some combination of:
- Worries about deflation, which is causing investors to buy bonds pushing their yields down. When inflation is low or negative, bond yields don’t need to be so high to compensate for any loss of purchasing power over time.
- Investors extrapolating current very low official interest rates off into the future – on the grounds that the longer rates stay low the longer they are expected to stay low – and so are pushing long term bond yields down to match. This is classic behavioural finance stuff.
- Worries that economic growth will slow necessitating further monetary easing and/or even lower official interest rates.
- Scepticism that the recovery in the US economy is sustainable.
- Safe haven investor demand for bonds in response to geopolitical concerns (Ukraine, the Insane State, etc).
- An increasing demand for safe income yielding assets as populations in developed countries age.
- A shortage in the supply of bonds as budget deficits are falling at a time when central banks are buying increasing amounts of sovereign bonds. In fact on some estimates net government bond issuance in the US, UK, Japan and Europe after allowing for central bank buying will be negative for the first time this year.
- Yields in "safe" high yielding countries like Australia being pushed towards convergence with low yielding countries by global investors chasing yield.
While many seem tempted to put all the blame on central banks on the grounds they are "artificially" keeping short term interest rates down and supressing the net available supply of bonds, I give more primacy to subdued economic growth and inflation/deflation. Central banks have only responded to these influences and the supply of bonds has a messy unreliable relationship with bond yields anyway.
In some ways the current environment strikes me as a mirror image of the early 1980s. Back then the big concern was that another 1970s inflation surge was just around the corner so investors demanded a huge premium (ie higher bond yields relative to actual inflation) to compensate for inflation risk. Now the fear is that sustained deflation, is just around the corner and so any positive yields are seen as attractive.
..but is it sustainable?
Ultimately, super low and in some cases negative bond yields are not sustainable. Over the long term nominal bond yields tend to average around long term nominal GDP growth. And on the basis of our long term nominal economic growth expectations current 10 year bond yields in major countries are running well below long term sustainable levels. See next table.
However, I and many others have been saying this for years and yet bond yields have continued to fall. Ultimately, a return to more normal levels for bond yields depends on central banks being successful in achieving their inflation targets and economic growth returning to more normal levels. The US is arguably further along this path but the rest of the world still has a fair way to go.
It’s noteworthy that historically bond yields have remained very low after a long term downswing for around 10-20 years, as it takes a while for growth and inflation expectations to really turn back up again. This can be seen clearly in Australian and US bond yields over the last two centuries with lengthy periods of low bond yields in the period 1890 to 1910 and in the 1930s to 1950s. See circled areas on chart below.
In a world of too much saving, spare capacity and deflation risk it’s hard to get too bearish on bonds (see The Threat of Global Deflation, Oliver’s Insights, January 2015). So notwithstanding periodic bounces in yields (eg bonds did have a tough year in 2013 and a US Fed rate hike this year could cause a spike in yields), yields could remain low for a while yet. At least until inflationary momentum really builds up again & there is a return to excess demand relative to supply in commodity markets.
What does it mean for investors?
There are several implications for investors. First, while Australian and global bonds returned 10 to 11% last year (as bond yields fell driving capital gains) don’t expect this to be sustained. The lower yields go, the lower the return potential from bonds. Over the medium term the return an investor will get from a bond will basically be driven by what the yield was when they invested. This can be seen in the next chart which shows a scatter plot of Australian 10 year bond yields since 1950 (on the horizontal axis) against subsequent bond returns based on the Composite All Maturities Bond Index (vertical axis). At 2.6% now we are off the bottom of the chart (ie record low yields) meaning record low returns for the next ten years.
Second, low government bond yields (along with low interest rates and term deposits) mean there is an ongoing need for investors to consider alternative sources of yield and return, including corporate debt, property, infrastructure and shares.
Third, low bond yields have the potential to drive a further upwards revaluation of other higher yielding assets. This is because lower bond yields allow other assets to also trade on lower earnings or rental yields and hence higher prices. This will have the effect, for example, of pushing price to earnings multiples for shares above longer term averages.
Fourthly, the search for yield will favour higher yielding government bonds over lesser yielding bonds resulting in an ongoing pressure for convergence. This could see the gap between Australian and global bond yields continue to narrow, resulting in higher returns from Australian bonds over global bonds. It could also benefit Greek bonds (which currently yield 10.2%) if the new Greek government gets its act together and agrees a new debt support and reform program with the rest of Europe -but don’t touch them with a barge pole if they don’t!
Finally, very low bond yields highlight a benefit of active fixed income management in that the portfolio manager can vary the exposure of the fund to credit and reduce the portfolio exposure to any rise in yields in order to protect investors once yields start to rise.
