Is the bond bull market over?

Is the 30-year bull market for government bonds nearing its end? We believe so. The short-term is impossible to predict but prospective real returns (i.e. adjusted for inflation) from US government bonds are likely to be negative over the coming five to ten years. We expect poor returns in the UK, Germany and Japan also.

Although the US 10-year treasury yield is up more than 40 basis points since July, it remains extremely low by historic standards (1.8%) and relative to consensus expectations for inflation.

The yield on inflation-protected 10-year government bonds in the US, UK and Germany are currently -0.7%, -1% and -0.2% respectively. In other words, the market expects inflation to exceed the redemption yield on equivalent nominal bonds (broadly speaking).

Is the bond bull market over?

So why choose bonds?

Of course, some investors anticipate prolonged deflation. But most do not. So why, you might ask, would anyone want to invest their savings in something that is very likely to provide them with less purchasing power in the future than today? After all, are we not supposed to require a positive real return to induce us to save instead of consuming our income today?

There is reasonable evidence to suggest quantitative easing (QE) has lowered bond yields and price insensitive buyers, such as foreign central banks or sovereign wealth funds, are also large players in ‘safe haven’ bond markets. But these actors are not the marginal buyer of bonds, where prices are set. We therefore require alternative explanations for why return-oriented investors would buy such bonds.

There are perhaps four plausible reasons. First, the investor thinks he or she will be able to achieve a positive real return and sell the investment in future to someone else willing to accept an even lower yield. Second, the investment is expected to provide a hedge to an overall portfolio should a shock impair the value of other holdings – an insurance policy, in other words.

Third, the redemption yield, while low, is still expected to exceed the return from cash or bank deposits. Or, fourth, investors are mainly concerned about their future spending needs but so risk averse they continue to avoid riskier growth assets such as equities.

These factors may help explain why yields are low currently, but they do not change the reality that future returns are likely to be low. The first explanation is not a sustainable equilibrium for obvious reasons.

The second has been true in recent years but will not always be so if default risk or interest rate risk become a major concern. The final two explanations are certainly conceivable but remain consistent with very low, likely negative, returns in real terms and investors would do better to look to other asset classes.

Bond bulls point to the experience of Japan, where the 10-year yield has remained below 2% since the late 1990s and bonds have outperformed cash and stocks. However, the Japanese experience over this period was characterised by ongoing deflation, sluggish growth in broad money and flat-to-declining nominal GDP.

The outlook appears very different for the US, in particular. There are clear signs the US economy is healing – the housing, labour and credit markets are all improving. Broad money supply (M2) in the US has grown at an annualised pace above 7% over the past three years. In Japan, it has not exceeded 4% since the late 1990s. With a healing economy and a proactive central bank, sustained deflation looks unlikely in the US.

While Europe is more similar to Japan from a growth and demographic viewpoint, we view a prolonged deflationary outcome at the overall regional level as unlikely, particularly given our views on the US and expectations for decent growth in emerging markets.

Equity friendly

What about the outlook for corporate bonds? In our view, corporate bonds are likely to continue outperforming cash and government bonds. But yields here are very low too: 2.7% and 2.1% for the Barclays US and eurozone investment grade indices, respectively. With corporate spreads now much lower than a year ago, there is limited room for further spread compression.

Moreover, if the world economy continues to improve we would expect corporate executive behaviour to become less “bond friendly” and more “equity friendly”: a less cautious approach with more M&A activity, share buybacks and capital spending. Unlike the past five years, we expect global equities to outperform corporate bonds (including high-yield) over the next five years.

What would make us wrong? If the world economy performs far worse than consensus expectations, possibly resulting from a major negative shock, then bond yields could of course decline further in the short-run. In the medium- to long-run, inflation would have to undershoot expectations significantly and policy rates remain extremely low to generate decent real returns. In our view, the far more likely outcome is that the future real return from G7 government bonds is very disappointing.

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