Broken income?

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Jon Jonsson, senior portfolio manager, global investment grade fixed income at Neuberger Berman, explains why core government bonds are no longer the safe havens they were.

“Four weeks ago, I wrote that technical forces were the real drivers behind negative yields in European government bond markets, and that anyone buying these bonds was taking a big risk.

The initial tick-up in yields at that time turned out to be the starting gun for a truly remarkable sell-off that saw the German 10-year Bund yield leap from 0.07% to 0.70% in just 17 trading sessions.

Complacency coming into sell-off

Complacency had built up in fixed income markets, thanks to an extended period of low yields. With the retrenchment, at least some of that appears to have evaporated. Core government bond indices in Europe have shed 3%-4% from their peak valuations, wiping out much of this year’s accumulated return.

At this point, a further 25 basis points of upward movement would eliminate 12 months’ worth of coupon income for all developed government bond markets; for Germany, that breakeven point is only five basis points away.

In our view, investors really need to question whether fixed income can play its traditional role as a provider of stable income with low risk to principal when priced at these levels.

They also should ask whether this was just a bounce in the longer-term trend of ultra-low yields or the start of something bigger.

Little change in growth and inflation expectations

After all, fundamental expectations don’t appear to have changed much.

The stabilisation of oil prices explains some of this sell-off, we believe, but indicators such as the five-year, five-year forward-starting inflation breakeven rate, for example, have barely moved: It remains just above 2% in the US and well below 2% in Europe.

Indeed, the near end of nominal and inflation-linked curves has not seen much of the action over recent weeks. Fed rate expectations for 2017 have moved up by less than 25 basis points; the market has not been pricing a more aggressive Fed for the near term.

In fact, we have seen the biggest re-pricing in very long-term rate expectations on the German curve, where the 10-year, 10-year forward rate, which had tumbled to as low as 1%, bounced back to around 1.75%.

We saw a similarly big move of 50 basis points in the same forward rate on the US curve.

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