By Laurence Mutkin, head of fixed income strategy at Threadneedle Although UK investors are show...
By Laurence Mutkin, head of fixed income strategy at Threadneedle
Although UK investors are showing rising enthusiasm for increasing their holdings of fixed interest versus other assets, the level of nominal bond yields is now around 5%, which is very low by historical standards.
Of course, we all know the nominal level of bond yields ' the sticker price, so to speak ' is not really as important an indicator of value as the inflation-adjusted, or real, yield. A nominal yield of 5% with inflation below 2% should be more attractive to investors than, say, a nominal yield of 13% with inflation between 15% and 20%.
But, even allowing for the fact investors should be concerning themselves with inflation-adjusted yields rather than nominal yields, the question remains as to whether the real yields available in today's bond market offer good value.
First, it is worth taking a moment to sort out our terminology. I would define the real yield as the present nominal yield less the present rate of inflation. So, does the real yield now available look good value relative to the real yields available in the past?
From the beginning of the First World War, around 1925 and during the 1970s and early 1980s, average real yields were negative.
This meant bond yields were lower than the rate of inflation. Investing in bonds could only help investors lose money more slowly. Changes in the level of the nominal bond yield were simply overwhelmed by the volatility of the value of money.
During periods of more stable money, when there was only moderate inflation, similar to the levels we have today, average real yields were typically lower than they are now.
When there was modest but not extreme deflation, nominal yields were about where they are now but, because inflation was negative, real yields were considerably higher.
During the recent past, average real yields have gradually been falling but they remain higher than they were during previous periods of low inflation by about 1.5 or two percentage points.
The conclusion from this is that there is scope for real yields to fall further. Given the benign inflation outlook, this argues for further falls in nominal yields. It is also worth pointing out that if modest inflation gives way to modest deflation, although there might be a smaller decline in nominal yields, the real return on bonds should increase.
But, even if real yields are now higher than they have been during similar periods, why should they fall now? The reason is that bonds are competing with other asset classes for investors' attention. Therefore, their real yields should ultimately depend on the real returns expected in the economy as a whole.
When the economy is growing quickly, real returns on investment should generally be high, which means real yields on bonds should also be relatively high.
In the low-inflation environment we expect now, this means that, even with apparently unattractive sticker prices, bonds can continue to perform well.
Real yields are good value.
Low inflation to underpin bond returns.
Bonds can do well even with poor sticker prices.
Bonds have unattractive sticker prices.
Strong growth rebound would hurt bonds.
Real yields are now falling.
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