Investors should ignore the noise around rising government bond yields and take a more strategic approach to fixed income investing, according to Vanguard’s Christie Gonçalves.
Gonçalves, government bond trader at Vanguard Asset Management, noted that concerns over the end of the bond bull market have increased as central banks start to unwind the stimulative policies of the past decade.
Government bond yields have been moving lower for some time and have continued to drop in the past decade with post-global financial crisis central bank policy driving further falls in yields.
However, the removal of stimulus could prompt yields to move higher resulting in capital losses for investors.
She said: “Looking back at the evolution of the US 10-year bond yield over the last three decades, many investors will be surprised to see that it was close to 10 per cent in 1987 and has trended downwards all the way to the current level of below 3 per cent.
“European and UK bond yields have followed a similar trajectory over the 30-year period, as shown in the chart below, with a number of corrections on the way.
“Prior to the global financial crisis, in the period between 2000 and 2007, yields were around 5 per cent and were in fact considered low for the time. The current yields are therefore nothing new.”
Source: Bloomberg
Gonçalves said quantitative easing (QE) measures following the crisis resulted in a sharp drop in bond yields, initiated by the Federal Reserve and later followed by similar polices from the European Central Bank and Bank of Japan.
“With global financial markets awash with cash, it is no wonder we saw bond yields take a further leg lower, with the German 10-year bund trading into negative territory,” the Vanguard trader added.
However, despite rate hikes by the Fed yields have remained “anchored” thanks to the effect of “exported QE”, or capital flowing to the most attractive markets.
Exported QE has had the effect of keeping yields lower than can be justified by the local central bank, said Gonçalves.
“Consider an investor in Japan who is getting increasingly negative returns on their assets due to the QE effect there,” she explained. “However, if they are able to buy US treasuries at above 2 per cent, that is a much better investment.
“We saw this in 2016 and 2017, when Japanese investors invested €87.6bn in US sovereign bonds.”
She said the flows of capital helped to keep US bond yields in 2016 and 2017 despite the less accommodative monetary policy in place.
Yet, investors are beginning to worry that yields may start to rise for a number of reasons.
First, central banks are beginning to reduce support for markets, said Vanguard’s Gonçalves. The central banks around the world have begun raising rates and scaling back QE programmes.
“With less central bank support for the economy, the expectation is that yields will drift higher,” she said.
Source: Vanguard
Secondly, the net supply of government bonds has started to turn positive as central banks begin reducing their QE programmes.
And thirdly, expectations of higher inflation have increased – as was demonstrated by the bout of market volatility earlier in the year when investors became alarmed that rates may tighten quicker than anticipated.
“Factors such as petrol price increases, wage growth and fiscal stimulus plans – tax cuts and infrastructure spend – all contribute to higher inflation expectations,” she added. “In theory, higher inflation should lead to higher yields and therefore lower bond prices.”
As such, some government bond investors may be worried that rising yields could result in capital losses. However, Gonçalves said there were some reasons for investors to take heart.
“Investors should remember two things. Firstly, it's difficult to anticipate how the market will respond,” she explained. “Similar headlines about the US 10-year bond hitting a 3 per cent yield proliferated at the beginning of 2017.
“However, last year, global fixed income enjoyed its best year in a decade, with the Bloomberg Barclays Global Aggregate Bond index returning 7.4 per cent – 2.04 per cent in sterling – to investors.”
Gonçalves added that there are mitigating factors that investors should pay attention to, such as central banks continuing to be supportive overall despite reducing the pace of stimulus and their pledges to keep any reduction gradual.
“QE is also still being added in the euro area and in Japan, albeit at a slower pace,” she said. “The stock of bonds on central bank balance sheets still remains high – around €12.7trn as of the beginning of January 2018 – and this will act to weigh on yields far into the future.
“The rate of change is declining, but is unlikely to turn negative at least until 2019.”
While some central banks have provided some guidance over when they will begin to withdraw stimulus and raise rates, Gonçalves said investors should not try to time the market.
Instead, she said investors should add exposure to non-correlated assets such as corporate bonds and equities to their portfolios to make them more diversified.
“Timing the market consistently is extremely difficult,” added Gonçalves. “A better approach may be a globally diversified portfolio which, along with equities, has an allocation to both government and corporate bonds, two sub-asset classes which don't always move together, meaning there can be a diversification benefit.
“Investors should also remember the vital risk-dampening role bonds play in a diversified portfolio – fixed income tends to have a drawdown that is much lower than equities and can therefore be a safer long-term investment.”