Normally government bonds are boring, but if you’ve followed the bond market over the last couple of years, they’ve been anything but. Not in a good way either. As US bond yields moved from effectively 0% to now 5% it has created huge losses across the world. Those holding those losses include some of the world’s best investors and biggest institutions. Some of the world’s biggest banks and pension funds are sitting on hundreds of billions in losses. Luckily at this point, not many have had to realise these losses but make no mistake they are there, and they are potentially a problem.
The higher bond yields go though, and the closer they get to a peak, the more compelling the case for investing in high quality fixed rate bonds. For our portfolios we hold overweight positions in defensive assets already but its primarily made up of cash, term deposits and floating rate bonds and notes. The question becomes whether bonds are becoming more attractive than those assets and indeed whether they are becoming more attractive than equities on a risk adjusted basis. When you consider their much-improved income there is a case emerging for increasing the allocation to high quality low risk bonds.
During the period of extremely low interest rates, I strongly recommended against holding fixed rate bonds in investment portfolios. Rates at almost 0% were a historical anomaly that were never going to stay that low and when they eventually went back up, the value of bonds fall. Meanwhile, investment managers everywhere seemed to be blindly allocating to bonds as a defensive asset when a unique set of global factors collided to create a once-in-a-lifetime bubble in bond prices.
Who can forget the weird anomalies that the era of super low rates created for bonds? There were the 100-year bonds issued by Austria paying less than 1% pa (they’ve since lost as much as -70% in value. But don’t worry if you hold them until the year 2120, you’ll get your money back). Crazy stuff. Then there were the bond yields for countries such as Germany, Sweden and Switzerland who saw the yields on trillions of dollars of their bonds go so low that they went negative for a period of time. Investors actually paid these countries to hold their money for them. Madness. It was always going to end in tears as soon as a level of normality returned.
That’s where we are now as far as bond yields go – more normal bond yields. Not much else in the world is normal right now but that’s part of the turmoil ahead as the world adjusts to these changes. However, with bond yields having increased so much it is now time to step back and reconsider fix rate government bonds as an investment. The case for bonds is starting to become attractive on both an absolute return and a relative basis. I expect money from equities will soon enough start flowing into the bond asset class in a substantial way.
You can now get 5% from US Government bonds, still considered to be the global benchmark for a risk-free investment. What it means is that every other investment needs to pay you more than this to be worth your while. How much extra will depend on the type of investment and the level of risk associated with it. For other countries bonds its similar rates but heading higher, for higher quality corporate bonds it’s more like 6-8% and for lower quality companies more like 9-10%.
If, like me, you are bearish on the stock market and believe we are still headed for a recession (my base case) or a deep recession (possible) then the case for bonds is becoming more compelling. The more the economy slows, the more likely it is that governments need to lower interest rates down the track. In that case, falling interest rates will deliver bond investors a further gain as bond values increase. While I think there is economic and financial pain ahead for investors if interest rates across the world staying higher for longer, there is a positive for investors as bonds emerge as an opportunity.
General Advice Disclaimer: This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.