Slowing global growth, weaker US jobs data and political turmoil in Europe have contributed to the current whirlwind that’s gripped financial markets. Risk off sentiment has taken hold as investors flock to safety. Government bond yields are cascading lower, with the 10yr US treasury (UST) first hitting 1.56% at close of business on June 24th following the UK’s historic ‘leave’ vote before continuing to grind lower past the 2012 low and closing at 1.38% on July 5th.
This being said, much of Europe remains negative yielding (see Europe – a more negative yielding world), as does Japan. The fact remains that with 31.5% of the JPM GBI Government index currently yielding below 0%, the 10yr UST out-yields 84% of government bonds in said index (chart 1) which comes as a surprise to many. With rates hikes effectively pushed further out; it looks likely that we’ll be seeing treasuries continue on their current trajectory towards 1.25% or maybe even 1% by year end, but even this is unlikely to remove its attractiveness vs. the rest of the world.
Factoring in the ECB’s corporate sector purchasing program (CSPP) and Japanese investors continuing their relentless hunt for foreign yield, demand for the corporate investment grade sector is well supported and the landscape becomes ever more downward sloping in both Europe and the US. The ECB is currently set to continue it’s CSPP to the end of Q1 20171 which should lead to further yield compression in Europe, forcing investors to look to the US for income and effectively leading to lower yields all around.
Where do we go from here?
“Low government bond yields are assumed to have a negative impact on fixed income returns, given the assumption that the next move in rates will be up and the lack of yield reduces the ability to generate return”2.
History tells us that when it comes to government bonds, what goes down, doesn’t necessarily come back up. Using Japan as an example (chart 2), we can see that over a 20 year period from 1995 to 2016, 10 year government bond yields have declined from over 4.5% to their current negative levels. Declining yields in the government bond market pave the way for capital appreciation if you carry the view that rates are unlikely to rise at any significant pace, as can be seen by annualised total returns for the BAML Japan Government index from the start of 2005 until June 2016 at 4.34%*. Compare this to annualised total returns of 5.03%* and 4.74%* for the BAML Global and European investment grade corporate indices over the same period and we can see that over the long term, attractive returns are possible with an expected lower level risk.
The government bond sector remains essential for conservative investors that place great emphasis on preserving capital and retaining high levels of liquidity. Even though total return may not be at the top of their list, it’s apparent that the current environment should see government bond yields move lower, leading to an appreciation of bond prices. Taking a view on the path of rate hikes comes with an air of caution as we all know the potential pitfalls of taking any market outcome as a given. Investors that are concerned about uncertainty surrounding rate paths can access fixed income markets via unconstrained ‘best ideas’ strategies that allocate assets in a dynamic manner allowing for flexible duration management whilst removing the constraint of a benchmark and positioning portfolios to seek opportunities across the global bond universe.
*USD, hedged. BAML: Bank of America Merrill Lynch.
1European Central Bank: https://www.ecb.europa.eu/mopo/implement/omt/html/index.en.html
2Nicholas Gartside, Marika Dysenchuk and Viren Patel, (May 2016). Back to the future: A guide to finding fixed income returns; JPMorgan Asset Management.