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sun sets on golden age of gilts

Key government bonds have enjoyed a powerful downward trend in yields, in part due to benign inflationary conditions that were supported by globalisation. More recently, the monetary response to the 2007-08 banking crisis (and subsequent downturn in trend economic activity) has been unprecedented, with quantitative easing policies extending the bull market in government bonds.

Despite the significant strength in higher-risk bonds in 2012, the backdrop over recent years has remained one tinged by crisis, most recently with respect to the debt problems engulfing many eurozone countries. The resulting combination of investor fear and policy support has been very positive for safer issuers such as Germany, the US and the UK, helping explain the dominance of long-duration government bonds funds amongst the top fixed income performers over the past three years.

However, gilt indices may have returned 530% since 1990 and 27% over the past three years, comparable with UK equity returns with significantly lower volatility, but it is a challenge to envisage similar performance going forward. The March-end yield of 1.78% on ten-year gilts (and lower still on US Treasuries and German Bunds) makes such an outcome mathematically difficult.

This means the best-case outcome for government bond investors is likely to be rather less stellar than that of recent years. With credit spreads having narrowed to more normal levels than those in the immediate aftermath of the 2008 and 2011 crises and nominal yields on corporate bonds consequently also at very low absolute levels, the implications for investors and the investment industry may be profound.

At the very least, multi-asset portfolios may struggle to deliver the expected level of nominal returns given the anaemic potential performance from the bond holdings that historically formed their core; it is mathematically difficult for bonds to match past levels of absolute performance across the fixed income spectrum. Investors may therefore need to consider the likelihood of lower investment returns, an unpalatable possibility at a time of sticky inflation and one which could lead to sustained pressure on fund management fees.

A risk worth taking?

One potential way to address this conundrum is to seek higher-returning bonds within fixed income portfolios. This is, of course, the objective of the central banks’ quantitative easing policies – to force investors into riskier assets that offer the potential for superior performance to sovereign debt. In another forum, we could debate at length the ability of such a policy to improve the economic outlook when many of the uncertainties are on the demand side of economies that continue to adjust to the realities of the hangover from their previous credit binges.

Yet the policies have certainly had at least a moderate impact in depressing government bond yields and stimulating demand for higher-yielding credit products. The exceptional performance of the latter part of the market in 2012 is testament to the power of this dynamic but it is not the only segment of fixed income that is bearing greater scrutiny.

Investors are also increasingly looking to previously more niche areas such as infrastructure bonds and local currency denominated emerging market debt to help maintain a healthy level of nominal performance. Such dynamics help explain why fund launches over recent years have been dominated by high yield and emerging market bond offerings, including a significant expansion of the emerging market corporate bond universe.

The heat is on

These are indeed enticing sectors in a scenario in which most assets re-price relative to a low and manipulated government bond yield. However, it is important to be aware that some of these markets are in danger of overheating – some members of the US Federal Reserve are starting to indicate early concerns about the potential for a credit bubble as a result of monetary policy.

Moreover, we have hitherto considered what we initially termed the best-case outcome for fixed income. While this may well be the most probable outcome in the shorter term, it would be remiss not to acknowledge the substantial risks to the assumption of low sovereign yields.

There are two clear scenarios in which government bonds could deliver unpleasantly negative returns; not only does this require considerable thought as to the appropriate level of government bond exposure (a well-rehearsed topic over recent years) but it is far from self-evident that investors will be comfortable with the performance of many of the aforementioned higher-risk bond investments that have been priced relative to rock-bottom sovereign yields.

The first and most-discussed scenario is the hope that a pick-up in economic growth eventually leads to tighter monetary policy and rising government bond yields. This might not seem immediately likely given the mediocre economic performance of developed countries and the ongoing commitment of their central banks to unconventional policy measures.

It nevertheless remains the goal of current economic policy and should not be discounted as a possibility, especially given more recent signs of life in the US economy. Even with the positive trigger for a normalisation of monetary policy, there is a risk that the re-pricing of the ‘risk-free’ rate would create a short-term shock to riskier assets – as in 1994 – even if the pick-up in economic growth subsequently proved able to weather monetary tightening.

The second potential outcome is gloomier and more relevant to specific countries. Italy and Spain have proven over recent years that even larger economies can suffer if investors lose confidence in their creditworthiness. While the UK is in a somewhat different situation – not least because it has its own currency – economic growth remains elusive and government debt continues to grow. These are not symptoms of a healthy economy and if gilt yields were to rise as a result of waning confidence in the country’s creditworthiness and longer-term growth prospects, we would expect significantly worse performance from riskier assets.

In either instance, fund managers must be mindful of the risk of at least a short-term break in the negative correlation between ‘safe haven’ government bonds and riskier assets that has broadly persisted since 2000. This would have a significant impact on traditional multi-asset portfolios that, in crude terms, use government bonds to dampen the volatility of equity holdings and have benefited significantly from investments in both asset classes over the longer term.

Uncertainty requires caution

One of the key conclusions from this discussion should be the level of uncertainty surrounding the outlook for fixed income and the trigger for any rise in sovereign yields. Uncertainty naturally besets any predictions of the future but is currently exacerbated by the unprecedented nature of the current crisis and the coordinated policy responses.

As a result, the breadth of probable outcomes is extremely unusual and forcing the fund managers we meet to think extremely carefully about how to construct their portfolios. Most are respectful of the technical support for riskier fixed income sectors such as corporate bonds but are also increasingly mindful that their sharp rally means that risks are more and more asymmetric.

Thus many managers are starting to consider how to build more defensive elements into a portfolio but we are seeing unusual disparities in how this is achieved; the decision to use cash, government bonds or short-dated corporate bonds as more conservative holdings is dependent upon which of the range of potential risk outcomes is deemed the most concerning.

Benign days are numbered

The only outcome that seems relatively certain is that the extended downward trend in government bond yields will not last for another 25 years. Many asset managers are seeking to prepare for a less benign backdrop to fixed income investing by launching more flexible products that do not necessarily rely upon falling yields to deliver positive absolute performance. These are likely to become increasingly important parts of investors’ portfolios as asymmetry of risk relative to return in traditional bond funds becomes increasingly stark.

But these flexible products come with greater risks and it is paramount to select managers who have the expertise and resources to manage them well; in this vein, helping to explain why some of the largest bond funds available are more flexible offerings from established teams with a history of adding value through such mandates, namely Templeton and Pimco.

Part of the Bonhill Group.