Beware Duration II
A year on we review the prospects for Government Bonds
Last July we warned about the dangers of duration in bond markets (Beware Duration – July 16). The Gilt market actually peaked on 12th August, a few weeks after our note. On that date the 10 year Gilt yield was a paltry 0.52% which implied a cumulative return of 5.32% to 2026. Over the following few months the yield rose almost exactly 1% leading to a fall in the price of 8.5%. Adding in some income, an investor lost 7.3% by January, more than the potential return out to 2026. Even after a rally since January, those same holders are still 3.8% below the level they started at last year and with the yield to redemption now at 1.21%, if yields stay constant, it will take 3 years to accrue enough return to get back to breakeven.
So the risk-reward trade off in Government bonds has become just like the proverbial ‘picking up pennies in front of a steamroller’. The upside is modest but the downside is considerable if yields continue to rise and carry on eroding capital. For every 1% upward move in yield of a 10 year bond, a holder should expect to lose about 8%.
Why should yields continue to rise? Firstly, inflation in the UK is currently at 2.6% and is projected to stay higher than the Bank of England’s 2% target for a little while yet. The swaps market implies a rate of inflation between 2022 and 2027 of 3.25%. So not only are returns paltry and the downside significant but the likelihood of losing money in real terms is very high.
Secondly, real returns have been throttled down by Central banks over recent years through extraordinarily lax monetary policy, but recent communications have been significantly more hawkish. Some commentators are forecasting an additional $1 trillion of supply of Government bonds over the next two years. So it would seem reasonable to expect real yields to increase. While Central Bankers will want to make adjustments to monetary policy on a very gradual basis, financial markets will move at their own pace – not normally gradual.
Overall, unless you think a global recession is on the way, the prospects for Government bonds look bleak. Given the massive flows into bond markets over recent years in the hunt for yield, a reversal of that trend will only add to the additional supply coming from Governments and with more limited liquidity, the rush for the exit could be disorderly. Our message is the same – beware duration.
By Jeff Keen
All data sourced from Bloomberg as at 18th July 2017
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