Government bonds issued by the world’s major advanced nations are the safest asset that can be held in a portfolio. They have also provided respectable returns, and not only through cyclical downswings, but looking back, also over a lifetime. The annualized return you would have earned from holding a portfolio of Australian government bonds between the end of 1990 and 6 June 2020 is a little more than 7%. In calendar year 2008, when the world was reeling from the GFC, Australian government bonds posted a return of 19%. In 2011, when the Euro currency crisis sent shockwaves through risk assets, Australian government bonds again delivered a positive double digit return. Now, since the global coronavirus crisis struck on 16 January, Australian government bonds have returned only 1.25%. But, at least it is not a negative return. Bond returns are still lowly correlated to equity returns, and were negatively correlated earlier this year when equity markets were tumbling. That was when negative correlations mattered, because it meant government bonds shielded portfolios in the face of deeply negative equity returns.
The question now is; what can you expect from your government bonds going forward?
In recent years the positive and solid returns received from holding government bonds have depended increasingly on capital gains than on running yield. In other words, returns have been driven by declining yields. The yield on a US 10-year Treasury bond has been on a downward trend for decades, from close to 8% thirty years ago, to now around 0.8%. Australian government bond yields resisted the gravitational pull for a while but have converged with US Treasury yields of late.
To understand why we have reached this point we need to look at what has happened to monetary policy over the years. Central banks in the past misread low inflation as a sure symptom of underutilization in the economy, and as a result maintained low cash rates for long lengths of time. What was really at play was a rise in globalization, which during the early 2000's put downward pressure on consumer prices. The blowback from this policy error was a build-up in financial imbalances. Then when crises struck – in 2008 and then in 2011 – it was too late and even lower interest rates become the required monetary medicine for the global economy. This is relevant today because the situation we are in now is the result of past monetary policy decisions: that is, policy rates everywhere are at their lower bound. The global coronavirus crisis was so serious that it required central banks to put to use every tool in their toolkit, in short order, and to use them with almost maximum force.
With little running yield to harvest from a basket of government bonds, and little room for yields to fall further, is there still a case for holding government bonds?
If something unexpected occurs that threatens risk appetite then the attendant flight to safety will most likely see government bond yields outperforming risk assets.
They may not deliver double digit returns but they will outperform in most such scenarios. That dynamic has not changed with the fall in bond yields.
But there is a scenario in which government bonds could, temporarily, disappoint.
That scenario is one in which the nascent economic recovery underwhelms. Will government bond yields fall in this scenario? Possibly not, and longer dated bond yields may indeed rise.
This seems counterintuitive and contrary to everything we know about bonds. Consider the fundamentals. A long dated government bond yield can be decomposed into three parts. The expected path of the cash rate, compensation for expected inflation and a risk premium. The risk premium compensates for volatility in the price return of the bond and for the uncertainty related to the future path of the real cash rate and inflation.
If that is all there is to it then surely bond yields will always fall when economic activity and inflation falls. This has almost always held true because it has been correct to infer that economic weakness would lead to monetary easing, first via cash rate cuts, and then via outright purchases of government bonds by central banks. Now, for the first time, that inference may not follow, simply because market participants may believe that there is little further that can be done by central banks. Furthermore, while bond markets may not expect further monetary easing they will certainly expect more fiscal stimulus, and with it more government bond issuance. This could lead to a rise in longer dated government bond yields, above and beyond what is justified by a better long term growth outlook that results from that additional fiscal stimulus. This would not be in the economic interest.
Central banks have to credibly indicate they can still ease policy if the situation requires. The upcoming FOMC meeting will be crucial in this regard. It will be a showdown between Chair Powell and the bond market. Since the Fed has been recently tapering Treasury purchases, long dated Treasury yields have been rising. Central banks have to bring markets into line with only the assurance that further easing measures are still possible. It won’t be easy but more innovation is possible when it comes to unconventional policy, such as targeting yield levels on long dated bonds, introducing more explicit forward guidance, and for the RBA, a focus on quantitative easing beyond just addressing market dislocations and yield curve control.
Are government bonds still a worthy investment then? While economic risks exist – and they do – then holding a bond with virtually no default risk remains an attractive proposition. Active management can help navigate a bit of turbulence ahead.
We think shorter to intermediate dated government bonds will deliver very stable returns but longer dated yields are at risk of rising further.
At the end of the day, even if longer dated government bond yields continue to rise and decouple from the macro economic backdrop, it will be self-limiting. The reason for this is because government bonds – and in particular US Treasuries - are the lynch-pin of the entire financial system. Indeed the good equity market performance of recent years owes much of its success to the low level of Treasury yields. This means that if government bond yields rise too much, equity markets will come under downward pressure as the relative attractiveness of dividend yields compared to government bond yields, shifts in favour of the latter. This relationship ensures government bonds will still provide a good hedge should equity markets weaken over the longer term.
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