In recent times, many column inches have been devoted in the financial media about an impending disaster in the High Grade/Government Bond market. As Government Bond specialists, we at JCB are amused to see many so-called financial experts comment on a product they have neither sold nor traded. Despite this obvious limitation, readers as an investment community are expected to take these musings as ‘gospel’.
This is a useful reminder for us all when reflecting on portfolio implications: “you wouldn’t hire a plumber to rewire your house, so why would you get an equity or credit investor to give you advise on Government Bonds”.
I might emphasise that we are not perma-bond-bulls. We pride ourselves on being balanced investors within a multi-asset context and encourage investors to maintain a well-diversified portfolio. This is well documented on our website and monthly commentaries. However, we are an active bond fund that appreciates volatility. In the last week we have seen an abundance of market commentary on the likelihood of Government Bond yield ‘melt-up’ that some facts need to be highlighted and cooler heads should prevail.
A quick recap of events
Let’s digest what happened in the initial period of 2018:
- Government Bonds sold off slightly
- US inflation printed slightly above expectations
- Oil continued to strengthen
- Semi-retired ‘Bond King’ Bill Gross said that Bonds as an asset class are entering a bear market, even though he believes they will still have a positive return.
- The much anticipated tax cuts have passed Congress in the US
- There were conflicting comments that the Chinese Central Bank will reduce exposure to their sizable US Government Bonds holdings, which were denied by the Chinese CB.
- Speculative shorts in US Government Bonds are at multi-year highs across the bond curve.
This is an identical situation we found ourselves last March, when the US 10-year yield then fell from 2.60% to 2.20% in a month. Yet here we are with US 10-year bonds trading at 2.55%. These are lower in yield than they were in March of 2017 (2.63%).
Note that as I type this, demand for the Australian Government's new 2029 Bond has reached $21 billion dollars (and growing) for a deal that is likely to be only $6-$8bn in size. Clearly someone likes bonds here.
If this is a meltdown or a ‘bondcano’, then I am on the wrong planet.
Back to basics
I need to highlight something important here that is an elementary rule of investing. Equity and Corporate Debt investors seem to think that a massive sell-off in bond markets is a good thing and that it will support increased participation in their markets. This couldn’t be further from the truth.
We could pen thousands of paragraphs on why this is a toxic outcome for equity investors but the main reason is that the risk free rate (US 10-year Government Bonds) enables investors to allocate money into and get a return from the most secure credit in the investment universe. If this bond starts selling off to the point where it yields an attractive return for investors, then capital will begin to flow out of riskier assets, and into the safety of US Government. This is particularly prevalent when the economy looks like it is about to slow (or indeed fall) into recession and usually when the Federal Reserve has slammed the breaks and raised interest rates too hard and too fast.
Note US 2-year bonds (2% yield) are returning above the dividend return of the S&P 500 (1.82%). This will not last forever as the longer term thematics of demographics, overloaded debt, and stagnant wage growth persist enabling the aggressive hunt for high grade government yield to continue
Where to from here?
In 2018, JCB foresees three rate hikes from the Federal Reserve. Historically, new incumbents to chair the Fed like to stamp their authority and have overshot on the tightening. Think Bernanke in 2006, Greenspan in 1987, and Volcker in 1979. Powell could join this illustrious club as tightening and Central Bank stimulus withdrawal continues into the mature phase of the business cycle. We expect there to be some give up in yields in the front end of the bond curve (2yrs). However, we do not see a sustained sell-off in the US 10-year or the longer part of the yield curve.
As one experienced foreign central banker mentioned recently, “If US10s hit 2.6% I’m buying with my ears pinned back”.
Make no mistake, we think 2018 will see volatility rise in bond markets. However, we do not expect yields on US 10-year bonds to blast past the 3% level in the foreseeable future. We have only closed above that level once since 2011. Ironically, that was on New Year Eve in 2013; another moment in time where delirious equity and high yield managers were sipping vintage French champagne and getting ready for another year of hard earned returns on the tailwind of Central Bank balance sheets.
In the unlikely scenario we have a sustained period above 3%, keep a close eye on your equity and corporate debt portfolios.