Rising risk appetite weighs on safe haven bonds, says HSBC’s Sels

Willem Sels, UK head of Investment Strategy at HSBC Private Bank comments on reducing its allocation to safe haven government bonds.

We have reduced our allocation to safe haven government bonds to a small underweight. Improved risk appetite, low income and the potential for a gradual increase in inflation expectations reduce the attraction of the asset class.

In our search for yield, we limit our duration exposure and prefer increased credit exposure instead. To the extent that higher yields reflect better growth prospects, we do not think it should be a problem for equity markets.

Following a five-year bull run in safe haven bonds (US Treasuries, UK gilts and German Bunds), they have started the year on a negative note. This is not surprising as the improvement in risk appetite that has been supporting equity markets lately makes it less compelling to own safe haven bonds. Rising growth prospects and the injections of liquidity are raising longer-term inflation expectations, pushing up longer-dated yields from their lows. Finally, the still very low current yields also reduce the attraction of bonds if one believes the world has become somewhat less scary: at low yields, the upside for bond returns is somewhat limited, and any increase in volatility can quickly leads to negative returns. Some more outspoken investors have started to call government bonds ‘return-free risk’, albeit in a slightly exaggerated way.

Low income and rising volatility, but only a gradual increase in yields

Our small underweight to government bonds is mainly motivated by the low yields, which limit the return potential for the asset class. As one can see below, the total return index for Treasuries already showed little improvement for much of last year, in spite of the very uncertain macro environment.

We think yield volatility will increase, and yields are likely to drift up this year, but that process should be gradual rather than abrupt, for several reasons.

We believe that the main factor behind the yield spike – and behind the equity market rally earlier this year for that matter – is the view that systemic risks have been reduced. The risk of a collapse of the financial sector has declined significantly as a result of the 3-year liquidity provided by the European Central Bank (ECB), and the Greek default has been handled in an orderly manner.

Reduced tail risk is positive for risk appetite and reduces safe haven demand, but once this is priced in, it may not lead to a continued drift for bond yields. In addition, we believe that significant uncertainties remain in Europe, which should lead many investors to maintain core holdings of safe haven assets in the portfolio, in spite of very low yields: markets will probably continue to worry about the potential of a  haircut in Portugal and potential slippage on deficit reduction implementation in much of the periphery, as a result of the deepening recession there. Shorter-dated Bund yields are also capped by the LTRO’s 1% cost, because if Bund yields were to spike above that, it would provide banks with a virtually risk-free carry opportunity.

Therefore, we believe that the path for government bond yields will be set by the  three usual factors, namely global economic growth, inflation expectations and monetary policy.

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