UK and US government bond prices are trading above fair value on a historic basis but Axa Investment...
UK and US government bond prices are trading above fair value on a historic basis but Axa Investment Managers is still using them to reduce risk in portfolios.
Nigel Richardson, senior strategist for the group, believes US government bond yields are below long-term fair value but has increased his weighting in the asset class as he feels they offer increased compensation against global growth risks.
The main change to asset allocation in the group's funds was a reduction in the underweight position in government bonds in May in response to a rise in yields in April. The reduced underweight was partly funded out of cash, which is still moderately overweight, Richardson notes.
'The US is the driving force behind the direction of international bonds,' he says. 'Lower core inflation has only partly justified the drop in US bond yields in the past few years. Yields are below what we consider to be fair.'
The yield drop in part reflects perceptions about the risk of future weak economic activity but is mainly a result of the flight out of equities into perceived security, Richardson notes. The popularity of government bonds reflects a bubble of pessimism, he adds.
'Such pessimism has left US Treasury yields below their credible long-term levels,' Richardson says.
'With trend GDP growth at around 3% and underlying inflation likely to be around 2%, fair value for US Treasuries is probably around 5%. At around 3.4%, therefore, 10-year nominal yields are too low.'
Richardson believes the main factor behind the overvaluation of the US bond market is the relatively low level of real yields.
Implied inflation expectations, the gap between nominal yields and real yields on inflation-linked bonds, are around 1.3%, moderately below the likely long-term trend, he notes.
Low real yields reflect a combination of perceptions of growth and the fact investors are still risk averse.
Richardson says: 'Real yields, therefore, are probably too low and we would eventually expect them to rise back to more normal levels.
'However, such a rise in real yields is unlikely until a fundamental rebound in US/global growth is confirmed and greater stability in equity markets instills less risk aversion.'
A slight increase in UK inflation to 3% means the real yields on gilts are now around 1%-1.5% points lower than their long-term average, according to Insight Investment.
Philip Barleggs, head of asset allocation at Insight, believes it is currently not desirable to increase bond exposure with yields at such low levels, preferring cash over fixed interest.
He says: 'Even if inflation falls back to its target level or below, a drop of about 50-100 basis points, and there is a return to average real yields, nominal yields would need to rise by about 0.5%-1% points. Such a rise in nominal yields over a six to 12-month period would result in a near zero return for gilts.'
The additional amount of bond issuance the Government will needs to undertake will only add to the supply side of the equation, he notes.
Bonds compensating global growth risks.
Inflation could fall back.
Cash strong alternative to governments.
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