The big bond sell off and prospects for fixed income

For an extended period, bonds represented a ‘risk off’ asset, a great diversifier relative to equities and a source of very attractive returns. Thus the US 10-year bond yield fell continuously over the 29 years from 1981 when yields were around 16%, to 1.5% last summer, and bond investors enjoyed annual returns of 9% per year. However, given the sharp rise in bond yields in May and June, US 10-year bonds have returned -5% for investors in the first half of this year, and global government bonds have done even worse, returning -8% over the same period, and total bond returns (including credit) have had their worst performance since 1994.

Against this backcloth, global bond funds have experienced net outflows of around $55bn (or 2% of assets under management) since early June, with the possibility that outflows persist, helping to cause further weakness in fixed income. Given that global bond funds have seen inflows of $1.4tn since March 2009, compared to only $10bn into global equity funds over the same period, there is clearly significant scope for an unwinding of the flows into global bond funds.

As for what might be the fair value of bonds, taking account of all the macro factors, US 10-year bond yield might reasonably shift to 2.7%, but if we assume 3% GDP growth, broadly consistent with ISM new orders at 55), then the fair bond yield rises to 3.1%. Meanwhile bonds yields are held down by quantitative easing and ultra low money rates but on a five-year horizon, real policy rates may well  rise to zero, suggesting nominal short rates moving to 2%, and core inflation will eventually pick up modestly (especially if Mr Bernanke’s likely successor at the Fed, Janet Yellen, is willing to pursue an easy monetary policy until inflation is 3%). With a Fed Funds rate at 2% and inflation at 2%, the fair-value 10-year bond yield would rise to around 4.1%.

As to how bond yields actually evolve from here, we see the most likely outlook for rates as a gentle upward trajectory with perhaps 2.75% 10-year US bond yields by year-end and 2.8% in Q1 2014. However, there is a clear risk that yields rise faster and further, and even after the recent rise, yields continue to be toward the bottom end of their 300-year range (looking at British government bond yields, with the data starting in the 1750s).

One of the supports for bonds over the past four odd years, has been the extraordinarily high levels of macro risk, which have been reflected in high correlations levels among asset classes. However, there has recently been a sharp reduction in negative tail risks as a consequence of developed market central banks’ policy of whatever-it-takes—in Euroland (the OMT), Japan (to generate 2% inflation) and the US (the Fed’s commitment to bring the unemployment rate down to 6.5%). The resulting fall in negative tail risks is reflected in the University of Stanford’s US economic policy uncertainty index, which has fallen to the lowest level since 2008.

Lower bond prices (higher bond yields are one consequence of lower tail risks, and more broadly, many of the assets that function as hedges against macro crises (gold and inflation-linked bonds, as well as the yen, which has traded as a ‘safe-haven’ currency) have sold off sharply over recent months.

Looking forwards on the prospects for these so-called ‘safe haven’ assets, whilst conventional bonds look pricey still, there’s a chance that 10-year TIPS yields have now overshot and an extraordinary feature of the recent sell-off in rates is the fact that inflation expectations fell sharply, even as nominal rates rose, leading to a rise in real rates that was even sharper than that in nominal yields. US index-linked bonds yield have risen from -70bps in March to +65bps at the end of June (though they have fallen back to 50bps since). This has been driven not only by the reduced demand for ‘safe haven’ assets, but also by a better-than-expected US fiscal outlook, a strong labour market (with the Fed linking its guidance to the unemployment rate), hawkish Fed rhetoric and falling inflation rates. However, to stabilise the US government debt to GDP ratio and unemployment, requires US real bond yields to be at 10bps. This suggests that TIPS yields have overshot – but even so, real yields of this magnitude aren’t much help to investors seeking adequate long term returns to fund their activities and to protect the real value of their asset base.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla