Government bonds, negative interest rates and the value of diversification

Bond investors are living in a topsy turvy world. The global financial crisis presented central banks with unprecedented challenges which were met with extraordinary actions. A decade on, we can now see that these measures saved the global economy from deflation and economic depression. However, the unintended consequence of these extraordinary measures was that they led to distortions in capital markets; particularly the fixed interest markets.

Currently bonds worth $13 trillion, more than a quarter of world debt, offer negative yields. In other words, a quarter of the world’s debt is guaranteed to lose money for investors.

It is difficult to comprehend a billion of anything let alone a trillion. To put it into context, a billion minutes ago, Jesus was alive and a trillion is one thousand times more than a billion. A trillion one-dollar bills stacked on top of each other would be 67,866 miles high, a quarter of the way to the moon. Stacked end to end, they would stretch to the Sun and beyond. A trillion dollars is an awful, awful lot of money and $13 trillion, well, is just unimaginable.

However, to return to the fact that for a quarter of the world’s debt, $13 trillion dollars’ worth, the lender is paying the borrower for the privilege of lending them money. This is obviously the complete opposite to a normal commercial loan arrangement. Interest rates are supposed to be positive; we aren’t supposed to pay people to look after our money. One Danish Bank even has a negative interest rate mortgage.

Bond yields are ultimately determined by the price investors are willing to pay for the underlying fixed interest security. The higher the price investors are willing to pay, the lower the yield becomes. When overlaying the low interest rate environment, combined with the global outlook on economic growth, investors are willing to pay ever higher prices for bonds to achieve an element of security. So much so, that the rising prices have seen investors purchase fixed interest securities with the guarantee of losing money, if held to maturity. These Investors are hoping for the greater fool principle whereby another investor will buy the bond before maturity.

UK Government Bonds have not entered negative yield territory just yet, although the yield on 10-year Gilts recently sank to their lowest level on record (below 0.5%). That is below the previous low reached in August 2016 after the UKs vote to leave the EU led to concerns about the country’s growth prospects.

WHY ARE BOND YIELDS SO LOW?

After the 2008 global financial crisis, central banks around the world cut interest rates. In the UK alone, interest rates fell from 5.25% to 0.50% over a 12-month period (March 2008- March 2009). In addition to interest rate cuts, central banks started to buy government bonds on a massive scale in a bid to drive down the cost of borrowing and to boost economic growth. This method of monetary policy is widely referred to as Quantitative Easing (QE).

The combination of interest rate cuts and QE increased investor demand for investment alternatives to provide some sort of real return whilst maintaining a degree of security. Thus, investors were willing to pay ‘over the odds’ for government backed securities, which consequently increased prices and therefore reduced the available yield.

Government bonds, especially those issued by developed market governments like the UK, are considered a safe haven at times of uncertainty and this has also helped to keep demand high.

Unfortunately, many areas of the government bond market no longer offer risk free, return but are risk, return free.

YIELD CURVE INVERSION—RECESSION OR FALSE POSITIVE.

In August this year, the yield on 2-year US Government Treasuries was higher than the yield on 10-year Treasuries. Typically, longer dated securities generate a higher return than shorter dated securities due to the greater risks involved and time to maturity. The longer the term, the more sensitive bonds are to interest rate movements and the possibility of the Issuer defaulting is increased.

When the yield for a shorter dated bond exceeds that of a longer dated bond, it leads to an inversion of the yield curve. So, in August, investors were in the unusual situation where they would accept lower returns for lending over a longer period than a shorter period. This is regarded as a sign that investors are nervous as they anticipate a low economic growth and a low interest rate environment. Banks typically borrow short and lend long and make money on the interest rate spread but a yield curve inversion means they cannot make a profit on normal lending arrangements so are discouraged from doing so and the economy stalls through lack of bank funding.

An inverted yield curve has historically been an indicator of a coming recession but the one thing it can’t predict is when this might happen. A potential recession could be months or even years ahead of us; or there might not be one at all.

There have been false inverted yield curve signals in the past and it might be that because of the length of the current economic expansion, investors are just simply nervous. The actions of central banks have also helped to manipulate bond prices over the past decade, and this could also be having an impact on the way markets behave.

WHERE COULD YIELDS GO FROM HERE.

With bonds performing so well in recent years, it means the scope for significant further gains could be limited.

Interest rates versus UK Government Bond yields – 1^st Jan 1990 to 31^st July 2019.

Bond Investors could experience greater volatility in the future. Current prices also increase the potential for losses as an increase in bond yields results in a corresponding fall in the capital value of the underlying security.

At the same time no one knows when things might change, and yields could technically go even lower. Both economic growth and inflation could stay muted for a long time yet and this could help to keep bond yields down. Pension funds also need to match members pension liabilities by buying bonds which could increase demand, drive prices higher and therefore reduce yields further.

Investing in bonds is traditional regarded as an effective way to diversify an investment portfolio. Bonds can provide an important safety shelter during turbulent times for financial markets and dampen down the volatility that comes with other investments like stocks and shares.

On the other hand, the current low yields could also mean that traditional cautious portfolios which historically have relied on an increase in bond prices when equity markets fall, may no longer be quite as cautious or safe as imagined. It is for this reason that for the time being at least, Clarion only use short duration bonds in client investment portfolios because they are less sensitive to interest rate and price movements.

WHAT ABOUT CASH.

Cash is a useful way to diversify an investment portfolio. However, in an environment of anaemic economic growth, it is unlikely that interest rates will rise significantly in the short term and even at modest rates of inflation, cash is losing value, and its spending power in real terms. Of course, everyone should have some accessible cash as an emergency fund but the only way to preserve the purchasing power of savings over the medium to longer term is to invest in real assets such as equity and property.

THE VALUE OF DIVERSIFICATION

In these uncertain times when the extraordinary monetary actions by central banks have resulted in distortions to the capital markets, a well-diversified portfolio is more important than ever.

The key principles for a well-diversified Portfolio are:

A good spread—a well-diversified portfolio should have a good spread of assets like shares and bonds.
Don’t be too focused—the portfolio shouldn’t be too concentrated on one particular stock, sector or geographical area.
Avoid home bias—invest in an international spread of assets.
Choose different strategies—It is important to remember that fund managers will have different investment styles and strategies.

Building a diversified portfolio that meets an investors objectives and needs can be complicated. This is where professional, expert advice can help. Clarion can make sure your investment objectives and attitude to risk are aligned in a well-constructed, diversified portfolio that with regular reviews, will stand the test of time and deliver competitive returns over the medium to longer term.