The last 40 years have seen an incredible bull run in bonds, as yields collapsed from double digits down to current rates of less than 2%. Incredibly, yields are less than 0% in some countries. Looking at a chart of developed market bond yields over the last 40 years, it may appear that bond yields are on an inexorable downward path.
Source: Bloomberg as at 25/08/2016
What if we were to look at a longer time scale? We are fortunate in the UK to have government yield data going back nearly 300 years. On this longer term historical perspective, the post second world war increase in yields looks like an abnormality, with the average yield between 1727 and 1950 being 3.6%. Since the mid-1970s, bond yields have been returning back towards this more normal range, before appearing to have overshot in the last few years below long-term averages. This longer term historical context is useful, as we often see comparisons with ‘pre-crisis’ levels – which can fail to recognise the pre-crisis period may well have been a historical aberration.
Source: DMO as at 28/08/16
Although growth and inflation are currently subdued compared to recent history, perhaps we have returned to more normal long run levels and should not expect a rebound to the levels seen in the 1990s and 2000s. Despite recent downgrades to growth, the UK economy is still expected to achieve nominal growth (real GDP growth + RPI inflation) in excess of 3% in 2016 and 2017. Therefore, it is natural to presume long gilt yields should be at roughly similar levels.
Current low yield levels are mainly due to central bank policy. While extreme monetary stimulus was warranted during the financial crisis, developed markets have found it difficult to wean themselves off a system of cheap money. To our thinking, US and UK interest rates should be slowly rising, not to overly high levels, but rising nonetheless. The Fed is most advanced down this process, having raised rates in late 2015.
Trying to predict future rate rises is often a fool’s errand. The Fed is reacting to a wide range of data, as well as swings in market sentiment, with members fearful of the unintended consequences of any rate rises – especially when places like Japan and the Eurozone, and now the Bank of England, are still undertaking quantitative easing.
While gilt yields may not rise imminently, and predicting the timing of any rise is very tricky, it will be difficult for long bonds to repeat the returns they have seen in 2016. Taking a long-term view, the risks are against chasing more duration at these levels. With long gilts yielding just a little over 1%, a small rise in yields can wipe out all your annual income and more. As such, we prefer corporate bonds, which offer investors higher yields than gilts and less duration risk.
Past performance is not a guide to future performance. The value of investments may fall as well as rise and investors may not get back the amount invested. Income from investments may fluctuate. Currency fluctuations can also affect performance.
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