Are bonds in a bubble?

The rise of negative bonds yields starts with how central banks set interest rates, according to the recent study from Quay Global Investors “Investment Perspectives” which looks at whether bonds are in a bubble and the shift from monetary policy to fiscal policy.

“Holding a negative yielding bond to maturity means certain economic loss. The only potential gain is to on-sell the bond for an even lower yield (i.e. finding a greater fool) before maturity, passing the certain loss to the buyer. This is not a bad definition of a bubble,” Chris Bedingfield, principal and portfolio manager at Quay Global Investors, said.

“However, we believe the rise of negative bonds yields is more complex. It begins with how central banks set interest rates.”

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He went on to explain that while central banks controlled the cash rate directly, their actions and price-signalling indirectly controlled long-term rates.

But it did not mean that sovereign bond yields were in a bubble, he said.

“That doesn’t mean buyers of negative-yielding bonds will not lose money. They certainly will, if held to maturity. However, if expectations are correct, they will lose the same amount of money as if they were holding cash over the same timeframe. Choose your poison: a certain loss (bonds) or an uncertain loss (cash),” he said.

At the same time, the 2017 Trump tax cuts changed everything as it created a very different scenario, given that there was no immediate threat of terrorism or war to justify increased spending and the economy was in good shape.

“What has happened is a substantial increase in government debt, for little or no real change in momentum in either the labour market or the economy. Despite the massive increase in government debt, the yield on the US 10-year Treasury (at the time of writing) is near all-time lows,” Bedingfield said.

However, the moment the voting public understood the government was not a household, there would be a seismic shift in markets, he warned.

“By increasing the deficit in favour of households (who are most likely to spend incremental money they receive) rather than the wealthy (who are most likely to save incremental money they receive), there is, for the first time in a generation, the real possibility that modern Western economies can achieve near full employment, improving wage gains and a corresponding return of inflation.”

So how did this scenario affect Quay’s investment process?

Bedingfield explained that the potential for increases in interest rates was not a worry and in fact, a return of inflation would be an overwhelming positive for long term real estate investors.

Although he admitted that part of themes and investment positioning was based on the shrinking middle class and low wages growth, a shrinking home affordability was positive for affordable apartment REITs, single-family homes and re-urbanisation of major cities.

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