Amidst a wave of news flow suggesting such an event is imminent, Aviva Investors head of multi-asset retail funds Peter Fitzgerald, takes a look at what to expect from portfolios if bond markets were to sell off.
Looking at the data, it is clear the current level of interest rates and bond yields is low on both an absolute and relative basis. Moody’s Baa corporate bond yields, for example, have declined from over 13% in the mid-1980s to below 5% today.
In addition to this, these yields were consistently higher than equity market earnings yields, as calculated from the inverse of the price to earnings ratio, from 1985 until the last couple of years. If you look at the ratio of bond-to-stock yields, the normal figure since 1985 has been 1.4 times, whereas today it is much lower, at around 0.8 times.
There are several other ways you can look at the situation. For instance, one can look at dividend yields rather than earnings yields, and government bond yields rather than corporate bond yields. While dividend yields, particularly in the US, are low in absolute terms, they are attractive relative to government bond yields.
Few investors will disagree that current interest rates and bond yields are low, but there are those who seek to justify current valuations and do so by arguing that the spread over government bonds makes them attractive. I disagree. Government bond markets have been manipulated and rates are artificially low.
The current yield on US high yield is less than 6%. It is evident that this is not high yield – in the traditional sense of the word – any longer. However, many investors are finding comfort in the spread of some 4% the asset class is offering above treasuries.
So, what does this situation mean? The problem that should concern every investor is what would happen to their portfolio if bond markets were to sell off or interest rates were to rise.
The recent performance of the market may provide an instructive example and assist us on formulating the scenario, given that talk of Fed tapering, or a reduction in the Fed’s rate of bond purchases, has received a lot of attention.
Equities would not be immune in this instance and, within equities, emerging markets would be likely to suffer more. The long-term story supporting equities may be powerful but it is just that; a long-term story. In the shorter term, you would be more likely to lose more money.
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