What was once a puddle of negative-yielding fixed income securities has now become an ocean, containing trillions of dollars of bonds. This phenomenon poses numerous challenges to investors – not least cognitive.
The minus sign in financial matters is often hard for the human mind to digest due to the theory of ‘money illusion’, which suggests people reflexively judge outcomes in nominal rather than real terms. This means we might still feel good if our salaries go up by 10% and consumer prices rise by the same amount, even though we will have gained nothing in real terms.
So the ‘sticker shock’ of negative yields should be easier to process if viewed alongside real yields, which have themselves been negative in a number of markets for some years now and sporadically so over the long sweep of financial history.
Crucially, regardless of yield levels, we think investors should consider fixed income assets in the context of their liabilities, and the outcomes they seek to achieve.
So even if they are looking for a positive nominal return in their overall portfolio, such bonds can still perform a sensible part of an overall asset allocation.
Could the collapse in global yields be due to a vast speculative frenzy? Despite the optical oddity of negative rates, we do not believe bonds are in the midst of a bubble in which the market completely decouples from fundamentals.
We base this view on the current level of real yields and central bank accommodation, as well as expectations for monetary stimulus. We also see little of the investor exuberance commonly associated with the latter stages of bubbles, other than persistently high bond flows in the US from retail investors.
While we are observing broad shifts in behaviour as people look for positive returns by taking on more risk, many investors are risk-constrained – so the changes remain marginal.
This means the current momentum in yields can continue, further boosting the performance of bond markets. Moreover, government debt in Europe and Japan can still deliver more than cash due to relatively steep curves, offering returns from ‘roll-down’ strategies. And US dollar- and sterling-based investors looking at these markets may also wish to consider potential returns after the uplift provided by hedging back into their domestic currency.
How low can yields go?
It would be tempting to call a yield trough, especially in the US Treasury market, given that the market has already priced in a lot of bad economic news and action from the Fed.
But because we face significant events over the coming months and years with binary outcomes, including the ongoing trade hostilities and the US presidential election next year, the potential range for yield moves remains particularly large.
If and when yields do turn higher, we do not anticipate a broad-based selloff, so long as inflation remains low and monetary policy retains its current trajectory.
In our view, meaningfully higher inflation is a pre-condition for a damaging reversal in global bond markets, as this would scupper plans for further monetary easing. That pre-condition is not currently being met, as consensus expectations for higher inflation have been repeatedly confounded over the past five years.
We study all these factors when making fixed income investments on behalf of our clients. As such, we are wary of assets that could be exposed as the weakest links within global fixed income in the event that central banks shift their policy stance or reaction function, triggering liquidity events. These include somewhat exotic parts of the market that have proven very popular as rates have declined; for example, areas where underwriting standards have weakened, like ‘covenant-lite’ leveraged loans.
But broadly speaking, we believe that when faced with the deluge of negative-yielding securities, investors should say: these are still just bond investments, requiring thoughtful assessment and risk-management, albeit ones with minus signs.
This is an extract from our CIO Outlook.