Since the end of the Great Recession, yields on government bonds from developed countries have fallen to historic lows. The bull market in stocks which began in March 2009, more than any other factor, has been driven by the fall in government bond yields.
With the Federal Reserve now increasing interest rates, investors are faced with a dilemma. If they own bonds already, should they remain invested? Inflation is reasonably subdued, and commodity prices have weakened recently as economic growth expectations have moderated once more. If investors own stocks they need to be watching the progress of the bond market: since bonds drove stocks up, it is likely they might drive them back down as well.
Bonds vs. Equities
The table below looks at the relative valuation of stocks and bonds in the major equity markets. The table beneath it is ranked by the final column, DY-BY (Dividend Yield-Bond Yield), which is sometimes referred to as the yield gap. During most of the last fifty years, the yield gap has been inverse, in other words, dividend yields have been lower than bond yields, the chart directly below shows the pattern for the S&P 500 and US 10yr government bonds going back to 1900:
- (Source: Newton Investment Management)
- (Source: StarCapital, Investing.com, Trading Economics)
The CAPE (Cyclically Adjusted Price Earnings Ratio and Dividend Yield Data) is from the end of March, bond yields were taken on Monday morning 8th May, so these are not direct comparisons. The first thing to notice is that an inverse yield gap tends to be associated with countries that have higher inflation. This is logical: an equity investment ought to offer the investor an inflation hedge, a fixed income investor, by contrast, is naturally hedged against deflation.
Looking at the table in more detail, Turkey tops the list with an excess return, for owning bonds rather than stocks, of more than 7%, yet with inflation running at a higher rate than the bond yield, the case for investment (based simply on this data) is not compelling – Turkish bonds offer a negative real yield. Brazil offers a more intriguing prospect. The real bond yield is close to 6% while the Bovespa real dividend yield is negative.
Some weeks ago, this article looked more closely at India and Indonesia. International bond investors should, however, be mindful of currency risk.
- (Source: Trading Economics, World Bank)
If past performance is any guide to future returns, and all investment advisors disclaim this, then you should factor in between 2% and 4% per annum for a decline in the value of the capital invested in Indian and Indonesian bonds over the long run.
This is not to suggest that there is no value in Indian or Indonesian bonds, merely that an investor must first decide about the currency risk. A 7% yield over ten years may appear attractive, but if the value of the asset falls by a third, as has been the case in India during the past decade, this is clearly not a profitable investment.
Looking at the first table again, the relationship between bond yields in the Eurozone has been distorted by the actions of the ECB. Nonetheless, the real dividend yield for Finnish stocks at 3.2% is noteworthy, while Finnish bonds are not.
Greek 10-year bonds are testing their lowest levels since August 2014 this week (5.61%) which is a long way from their highs of 2012 when yields briefly breached 40% during the eurozone crisis. Emmanuel Macron’s election as France’s new President certainly helped, but the Germans continue to baulk at issuing Eurobonds to bail out their impecunious neighbours.
Stocks and bonds are both historically expensive. They have been driven higher by a combination of monetary and quantitative easing by central banks and subdued inflation. For long-term investors, who need to invest in fixed income securities to match liabilities, the task is Herculean. Precious few developed markets offer a real yield at all and none offer sufficient yields to match those pension liabilities.
During the bull market, these long-term investors actively increased the horizon of their portfolios while at the same time the coupons on new issues fell steadily: new issues have a longer duration as well. It would seem sensible to shorten portfolio duration until one remembers that the Federal Reserve are scheduled to increase short-term interest rates again in June. Short rates, in this scenario, will rise faster than long-term rates. Where can the fixed income portfolio manager seek shelter?
Emerging market bonds offer limited liquidity since their markets are much smaller than those of the US and Europe. They offer the investor higher returns but expose them to a heady cocktail of currency risk, credit risk and the kind of geopolitical risk that ultra-long dated developed country bonds do not.
A Workable Solution?
A workable solution is to consider credit and geopolitical risk at the outset and then actively manage the currency risk, or sub-contract this to an overlay manager. Selling long duration, low-yielding developed country bonds and buying a diversified basket of emerging market bonds offering acceptable real return and then, given that in many emerging markets corporate bonds offer lower credit risk than their respective government bond market, buying a carefully considered selection of liquid corporate names too.
Sadly, many pension fund managers will not be permitted to make this type of investment for fiduciary reasons.
The Crux of the Matter
So, to answer the title question: yes. There is still value in the government bond markets, but given the absence of liquidity in many of the less developed markets, which are the ones offering identifiable value, portfolio managers must be prepared to actively hedge using liquid markets to avoid a forced liquidation. Currency hedging is one aspect of the strategy, but the judicious use of interest rate swaps and options is a further refinement that managers should consider.
Actively managing currency risk (or delegating this role to a specialist currency overlay operator), while not entirely mitigating foreign exchange exposures, substantially reduces them.
Emerging market equities may well offer the best long-run return, but a portfolio of emerging market bonds, with positive rather than negative real yields, is far more compelling than the continuously extending duration of obligations among the governments of the developed world.