Anthony Doyle, director & head of Fixed Income Investment Specialists at M&G Investments
Government bond yields are extremely low across the globe. The highly unusual phenomenon of negative bond yields – even on debt issued by countries that still face a debt crisis – is now commonplace. In addition, investors are looking to protect themselves from the carnage in bond markets we have seen in recent weeks.
So where should fixed income investors invest, particularly after the moves in yields we have seen in recent weeks? Should they remain in government bonds and enjoy the perceived safety of owning a risk-free asset, or should they be willing to accept higher levels of risk in order to chase the higher returns on offer in investment-grade and high yield corporate bond markets? Perhaps a more relevant question is: what is the potential downside of owning bonds?
Looking at historic returns, drawdowns and correlations give a useful guide to how fixed income returns might be impacted in a world of rising yields. However, the collapse in yields across the fixed income spectrum now means that investors are at greater risk of higher drawdowns than ever before, and the income component of their total return is unlikely to adequately compensate for any hits to capital returns like it would in the old days.
The conclusions we can draw from an analysis of drawdown data are:
- Now more than ever, duration positioning is contributing to bond returns.
- It would not take much in terms of higher bond yields to cause a record drawdown in government bonds. Interest rate hikes or higher inflation could cause a significant move higher in bond yields.
- Future returns from fixed income are likely to be much lower than investors have historically experienced.
- Government bonds have and do experience losses. Arguably, the chances of losses have never been greater given the collapse in bond yields around the world.
- If corporate bond spreads were to rise (due to investors pricing in a higher default premium) in tandem with higher government bond yields the above return scenarios would be optimistic.
Of course, there are some very good reasons to own government bonds. High global debt levels, structural deflationary forces and the global savings glut mean that over the long term, government bond yields may not increase to levels seen a couple of years ago. As the drawdown analysis above shows, government and investment grade corporate bonds tend to be less volatile, have lower drawdowns and have proven to be less correlated with higher risk assets like high yield corporate bonds and equities.