Is the bond market a bubble?

Historically low interest rates in developed countries have helped government bonds become star performers, but is this all about to change, asks Steve Garth?

This move in yields to historic lows has occurred as central banks in many developed economies have cut official interest rates close to zero to boost activity, while holding down long-term rates by printing money and buying bonds. 

On the demand side, some investors wary of the share market have been willing to pay a premium for traditionally low-risk assets such as government bonds. 

Others have chased yield in corporate paper, resulting in a compression of bond spreads. 

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Consequently, many commentators are saying that the bond market is at risk of a substantial correction. Some talk of a repeat of the bear market of 1994 when unexpected central bank tightening spooked investors. 

Certainly, with interest rates in developed countries close to zero and yields at unprecedented lows, it does appear there is only one way for rates to go. 

Bond returns have been stellar now for years, but can they continue to be as good?  

Keep in mind that many forecasters who tried to time the market in recent years have ended with egg on their faces. Some called a bubble two years ago. Yet yields have remained low and bonds returns have been strong. 

So attempting to forecast interest rate and bond yield movements is not likely to be a successful strategy for long-term investment in fixed interest. 

Instead a few old principles apply: the importance of working with markets rather than against them; only taking risks where you can see an expected reward; diversifying both across and within asset classes, watching costs and exercising discipline. 

Most of all, success requires setting an asset allocation based on your own situation, goals and risk appetite, not on what is happening in markets at any particular time.How we got here 

The causes of the decline in bond yields in recent years are multiple, but broadly speaking break down into investor risk aversion in the wake of the global financial crisis; extraordinary policy action by central banks; and a hunt for yield. 

The action by central banks is unprecedented. In the US, the Federal Reserve last year embarked on a third round of so-called ‘quantitative easing’. This essentially means it is buying financial assets and pushing more money into the system. 

• Each month, the Fed is buying US$85 billion of mortgage-backed securities and longer-term Treasuries. It has said it will continue to do this and keep its target rate at between 0-0.25 per cent “for at least as long” as the US jobless rate remains above 6.5 per cent. The rate was at 7.9 per cent in January. 
• The European Central Bank calmed markets last July when it said it was prepared to do whatever it took to preserve the euro. To date, it has not seen the need to spend a cent from its Outright Monetary Transactions program. 
• Japan, too, under a re-elected Liberal Democratic Party government, is mounting aggressive action to curb deflation.  This includes a fiscal package and the promise of further monetary stimulus. 
• Here in Australia, the RBA has cut cash rates by a net 1.75 percentage points between November 2011 and December 2012 to historic lows of 3.0 per cent. The market is priced for at least one further move. 

Alongside central bank action, recent economic news has been favourable to bonds, with the partial resolution of the US fiscal ceiling showdown, the easing of the worst fears around the euro zone and benign inflation readings in the developed economies, including Australia. 

Those who say bonds are “overpriced” or a “bubble” must not only consider these policy initiatives and fundamental signals, but have to consider that there has been strong demand for safe haven assets.

People have been prepared to pay a high price for safety, which is another way of saying they have been prepared to accept a lower expected return to ensure the security of their capital. 

With sovereign bond yields so low and with central banks signaling continuing expansive monetary conditions, many yield-hunting investors have been aggressively buying corporate bonds. This has driven down spreads and made it more attractive for companies to raise capital in credit markets. 

Will interest rates go up?  

It is not widely appreciated that bond markets are extremely efficient and price news almost instantaneously. The global bond market is about twice the size of the equity market and is dominated by institutional investors. 

Expectations for further interest rate movements can be seen in the yield curve, the trajectory drawn by securities of the same credit quality across varying maturities. 

Normally, yield curves are upwardly sloping, which reflects the additional compensation demanded by investors for the risk of inflation depressing the value of bonds of longer maturity.

But sometimes curves can be flat or inverted, which can reflect the expectation that risks to inflation and growth are on the downside and that short-term interest rates will need to fall. 

Yield curves vary across economies 

Chart 5 shows yield curves for Australia, US, Japan and Europe, in local currency terms, as at 31 December 2012.

You can see the Australian curve was inverted in shape, which reflected a market view of a further slowdown in the local economy and the chance of further cuts to the RBA cash rate.  

In other markets such as US, Japan and the Europe, the yield curves were upwardly sloping, reflecting the views of some that rates will go up in time.  

Can yields get any lower? It shouldn’t be surprising that we don’t think it pays to speculate. People were saying two years ago that yields were unsustainably low.

The important point is that global markets have already priced in the expectations that yields may change over time. What will change those expectations is news. And no-one has worked out a reliable way of forecasting that.  

Keep in mind, also, that there is a difference between official interest rates, as set by central banks, and the wholesale rates set in bond markets.

So when you hear the phrase “interest rates are set to decline in Australia” this is referring to expectations for the Reserve Bank’s cash rate.  

Conversely, what happens to overnight rates is not always mirrored in the longer parts of the yield curve.  

Bonds as a diversifier  

Not only do cash, short-term bonds and long-term bonds perform differently, fixed interest has an historically low correlation with equities. So regardless of your view on the value of bonds at this point, they still act to diversify your portfolio. 

Take a look at Chart 6, which compares the annual performances of the Australian share market over 25 years with that of the Australian bond market. 

Bonds acted as a buffer to equities’ weakness in the 1987 crash, the early 1990s recession, the early 2000s ‘tech wreck’ and, of course, in the GFC of 2008. In fact in this 25-year period, there were only two years (1994 and 1999) of negative bond returns (-4.69 per cent and -1.22 per cent respectively).  

So not only do bonds diversify your portfolio, but those years of negative return don’t have to mean a realised capital loss on your bond investment. This occurs only if you sell your bond. 

So, for example, in the years subsequent to those negative returns of 1994 and 1999 bonds delivered returns of 18.68 per cent and 12.05 per cent respectively.  

And remember, even when bond prices fall, you still receive income from the bond in the form of a coupon. 

But diversification does not just apply to equities versus bonds; it applies within bonds themselves. You can moderate risk in a fixed-interest portfolio by diversifying across maturities, countries of issuer, currencies and types of issuer.  

Risk and return in bonds vary with your exposure to term risk (the length of the loan) and credit risk (the likelihood of a default). 

While volatility increases as duration lengthens and as credit standings fall, so does expected return. Conversely, while volatility is lower in short-duration bonds and those with high credit ratings, so is expected return.  

Global diversification in bonds can minimise the risk of unexpected changes in yields. This is because different economies have different interest rate cycles due to their varying expectations for growth and inflation. 

Diversifying across different yield curves and hedging the currency exposure back to the Australian dollar increases your opportunity set and spreads your risk. 

Summary 

Record low interest rates and bond yields around the world are prompting concern among some investors about what happens to their fixed interest portfolios when rates begin to rise again. 

There a few points to take away from this: 

• There are fundamental reasons for the fall in yields. Central banks have cut cash rates to historic lows and put a lid on long-term rates through unconventional monetary policy. Investors have sought a safe haven in government bonds, driving down yields, while plentiful liquidity has narrowed spreads in corporate bonds. 
• Markets have already priced in higher rates. In the US and Europe, yield curves are upward sloping. In Australia, the curve has been inverted, reflecting the view that cash rates here may fall further. 
• So while you are perfectly entitled to have a view about where interest rates are headed, there is no expectation that that is not already in the price. And you are not going to build wealth long-term by second guessing the market. 
• Short-term and long-term bonds move independently of each other. If you stick to term deposits, you are going to be sensitive to changes in cash rates. But there are opportunities in fixed interest regardless of what central banks do. All you need to do is diversify around risks that are worth taking and exercise discipline. 
• If rates rise in a way not anticipated by the market, there is still no guarantee this will result in realised losses in your bond portfolio. That occurs only if you sell your bond. When bond prices fall, you are still receiving income from the bond in the form of a coupon. 
• While a negative return can never be ruled out, 1994 was the only year in the past 26 when longer-term government bonds delivered a negative return. Even then, you would have only suffered a real loss had you sold.  
• Global diversification in bonds can minimise the risk of unexpected changes in yields. As one market zigs, another tends to zag. 
• You have options within fixed interest depending on your age, risk appetite and goals. For some people, longer-term bonds and a mix of credits are best. For others, short-term and only the highest rated credits are more suitable. Advisers can choose the best option for clients. 

Steve Garth is a portfolio manager at Dimensional Fund Advisors.