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Investors are preparing for a bear market in bonds, following a disappointing start to the year.
Government bond prices have experienced a pronounced sell-off so far in January, with yields, which move in the opposite direction to prices, spiking.
Yields on 10-year US treasuries have hit 2.72%, their highest level since 2010. Earlier this month, renowned US bond manager Bill Gross declared the start of a 'bond bear market', while his fellow fixed income heavyweight across the pound, Jeffrey Gundlach, said he expected a continued rise in yields through the course of the year.
The jump in yields is significant because it threatens to derail the 35-year bull market for bonds. If this is the case, investors will need to re-evaluate how they allocate to bonds.
‘Due to US leading indicator data, the added impetus of tax cuts, strong synchronised global growth, and the return of the missing link of US confidence as I outlined last year, I think the probability of the recent bear market in bonds stopping at this point is limited and it is why I remain short duration across my portfolios,' he said.
Expressed in years, duration is the measure used to show a bond fund’s sensitivity to interest rate changes. Rising interest rates are bad for bonds because it makes their returns look less attractive. Rates also tend to rise when inflation is increasing, which erodes the fixed income that you lock into when you buy a bond. Inflation expectations – upwards or downwards – can therefore have a significant influence on the performance of the bond market.
Peter Elston, chief investment officer at Seneca Investment Managers, notes that inflation needs to remain very low for developed market bonds to offer real returns. In his opinion, this scenario is unlikely because it runs contrary to central bank policies around the world.
‘For real returns [after inflation] from bonds to be in line with their long-term average of around 2% per annum, inflation must be negative. And for the high real returns seen over the last 35 years to be sustained, the scale of deflation has to be unprecedented,’ Elston said.
As central banks are doing everything in their power to avoid deflation, the chief investment officer believes that the investment case for bonds looks negative right now.
‘The point is that it is very possible that we will not see the deflation or very low inflation that would enable decent real returns from bonds. Central banks have worked it out. Do you really want to bet against them?’ he asked.
David Absolon, an investment director at Heartwood Investment Management, expects to see higher inflation in the US this year. Back in December, core inflation stood at 1.8%.
He is forecasting global economic growth to translate into higher demand and spending, which will ultimately feed through to prices. Likewise, an uptick in oil prices will also have an impact.
‘Admittedly wage growth has been disappointing so far, but we expect that tighter labour market conditions will eventually feed into higher wage setting,’ Absolon added.
The investment director is particularly nervous about the potential for higher inflation at a time when central banks across the globe are moving from quantitative easing to quantitative tightening (a phrase which refers to the withdrawal of stimulative policy).
‘Reduced global market liquidity is likely to receive more market attention as the year progresses. While the Fed is already reducing its balance sheet, the European Central Bank will end its asset purchase programme in September. Furthermore, the Bank of Japan has already announced that it will reduce longer-dated Japanese government bond purchases,’ he added.
He suspects the end result will be increased volatility in the bond market in 2018.
Chris Iggo, fixed income chief investment officer at AXA Investment Managers, expects inflation numbers to firm up in 2018, driven by higher global economic growth. Nevertheless, he points out that interest rates and yields remain low relative to history.
‘Yields are rising but it is no bond rout,’ he said. ‘There is not likely to be a rout until there are signals about a change in monetary guidance from Frankfurt or Tokyo. Until then, yield starved investors in Europe and Japan will continue to be supportive for fixed income markets.’
The flipside of falling prices is that yields will rise; once the 10-year US treasury yield reaches 3% it will represent an important milestone, Iggo says. This is because it represents a yield level that is likely to attract investors back into the asset class. Notably, this would include institutional investors, such as pension funds.
‘If we get to 3% in US treasuries and close to 1% in [German] bunds, it's probably time to buy,' he said.