Investors have been selling equities and buying bonds all year, with bond funds adding $189 billion in assets year-to-date. Within bond strategies, money is flooding out of alternative credit and more non-traditional areas of the market and into the lowest yielding, even negative yielding “high quality” areas. The trend is alarming for several reasons.
A negative yielding bond is, in effect, a commodity. And as Warren Buffet has said, “The problem with commodities is that you are betting on what someone else would pay for them in six months. The commodity itself isn’t going to do anything for you….”
Bonds have long served as the anchor in a conservative portfolio, a “safe haven” asset with an income component designed to produce a consistent return stream. As the amount of negative yielding debt now exceeds $10 trillion globally, bonds increasingly cease to trade based on fundamentals, such as yield, and trade instead on what someone else might be willing to pay for them in the future.
The chart below is a dramatic case in point: A Swiss government bond maturing in 2049 trading at over $130 above par! With premiums of this magnitude, bonds are effectively commodities, and investors are using the greater fool theory as an investing strategy.
On a real yield basis, the US Treasury is hardly a “gift”
And what about government bonds with positive (albeit very low) nominal yields? Compared with the negative yields in Japan, and parts of Europe, the yield on the 10-year US Treasury (UST) appears attractive, currently trading at around 1.6%. It also looks appealing compared with developed markets like Canada (1.1%), the UK (0.8%) or South Korea (1.4%).
However, on a real basis, these nominal yields are significantly negative as well. Adjusted for inflation, these yields range from -0.2% to -1.1%, as shown in the chart below.
This fact has significant implications for many investors. From an institutional investor whose return target includes CPI to an individual who needs sufficient retirement income to cover spending needs, negative real yields create just as much of a conundrum as do negative nominal yields. Furthermore, at a real yield of -0.8%, the 10-year US Treasury isn’t even the best house in what appears to be a very dangerous neighborhood for investors.
Central bank control: tenuous at best
This issue seems to have a relatively easy fix – why wouldn’t central banks simply raise interest rates? Let us be clear here – we absolutely believe this is a logical step for the US Federal Reserve to take. The constructive nature of US economic data is at odds with the emergency level of fed funds established in the abyss of the financial crisis.
However, while central banks have shown they are certainly capable of driving rates lower, they have yet to prove they are able to drive market rates up. Should we see further hikes from the Fed, what is to prevent a further flattening of the yield curve? Last year’s hike has already led to significant flattening – today the difference between yields on the 10- and 2-year US Treasuries stands at just 83bps. This figure was close to 300bps in early 2010, and since the beginning of 2009 it has averaged almost 200bps, which makes the current spread two standard deviations below the recent average.
So the Fed, and other central banks, face a difficult choice. They can continue to push rates lower – a strategy that is proving to do little for economic growth, and actually hurts financials; or, they can push policy rates higher, but with little impact on market rates and the added risk of creating panic in bond markets.
Perhaps this is one reason we’ve seen the Fed managing to market sentiment – interpreting essentially the same constructive stream of economic data in different ways at different times, depending on where markets were at the time of the meeting.
The bottom line, as we see it: In the wake of unprecedented quantitative easing, central banks may have painted themselves into a corner and lost their ability to alter market rates.
Only time will tell if central banks can find creative solutions in normalizing interest rates without disastrous side effects such as a yield curve inversion. One way or another, market forces will eventually prevail and return the income component to bonds. Until then, investors should consider diversifying into more flexible strategies with a much broader toolbox across traditional, alternative and private markets.
Oksana Aronov is managing director, JP Morgan Investment Funds – Income Opportunity Fund